Cash-Out vs. Rate-and-Term Mortgage Refinancing Loans

"Cash out" and "rate/term" are your two basic choices when you're refinancing your mortgage to save money. If you simply refinance your existing loan, to get a lower interest rate or change the terms, it is called a rate/term refinance. Or, you may want to extract some of the equity in your house—maybe to do a renovation, pay down debts or help pay college costs—with a cash-out loan. Here's what these two terms mean and how they can affect your financial position. 

First, think of refinancing as the replacement of an existing mortgage with another, or the consolidation of a pair of mortgages into a single loan. Out with the old (mortgage) and in with the new, as they say. Once you refinance, your old loan or loans are paid off, and a new one is put in its place. 

There are plenty of reasons to consider refinancing. Saving money is the obvious one. In August 2008 the average 30-year fixed mortgage had an interest rate of 6.48%. After the financial crisis, rates for the same sort of mortgage steadily declined. In December 2012 the 30-year fixed mortgage rate was slashed nearly in half from four years earlier to 3.35%. The average annual rate for 2017 was 3.99%. By 2018, the annual rate had risen to 4.54%, according to Freddie Mac, and it was 4.27% in March 2019, a 60-week low. But even these higher rates could be lower than older mortgages you might have.

Currently, however, mortgage rates hit a 60-week low in March 2019. In the week ending March 29, 2019, mortgage applications rose 18.6%, according to the Mortgage Bankers Association. The refinance level increased 39% to 47.4% of total applications, the highest level since November 2016. (The biggest recent wave of mortgage refinances hit from 2011 to 2013 and 2015 to 2016, when interest rates were near record lows.)

But historically, rates are still relatively low—one reason for homeowners with older, higher-interest mortgages (or those whose home equity has risen, or who have much better credit ratings than when they originally financed their home) to look at refinancing now. When rates are moving higher, refinancing can offer a chance to convert your adjustable-rate mortgage into a fixed-rate one, to lock in lower-interest payments before rates climb even higher. Industry authorities are predicting that rates will rise in 2019.

There are two basic refinance loans. The simplest and most straightforward is the rate-and-term refinance (refi). No actual money changes hands in this case, outside of the fees associated with the loan. The size of the mortgage remains the same; you simply trade your current mortgage terms for newer (presumably better) terms.

In contrast, in a cash-out loan, aka cash-out refinance, the new mortgage is bigger than the old one. Along with new loan terms, you’re also being advanced money—effectively taking equity out of your home, in the form of cash.

You can qualify for a rate/term refi with a higher loan-to-value ratio (the amount of the loan divided by the appraised value of the property). It’s easier to get the loan, in other words, even if you’re a poorer credit risk because you're borrowing a high percentage of what the home is worth. 

Cash-out loans come with tougher terms. If you want some of the equity you’ve built up in your home back in the form of cash, it’s probably going to cost you—how much depends on how much equity you have built up in your home and your credit score. For example, if a borrower’s FICO score is 700, the loan-to-value ratio is 76% and the loan is considered cash-out, the lender might add 0.750 points to the up-front cost of the loan. (Each lender is different.) If the loan amount were $200,000, for example, the lender would add $1,500 to the cost. Alternatively, the borrower could pay a higher interest rate—0.125% to 0.250% more, depending on market conditions. 

Why the tougher terms? Because cash-out loans carry a higher risk to the lender, according to Casey Fleming, mortgage advisor, C2 Financial Corporation and author of “The Loan Guide: How to Get the Best Possible Mortgage.” “Statistically a borrower is much more likely to walk away from a home if he gets in trouble if he has already pulled equity out of it. It is particularly true if he has pulled out more than he initially invested in the down payment. Consequently, any loan that is considered cash-out is priced higher to reflect that risk, until there is so much equity that the borrower isn’t likely to walk away anymore.”

But a higher credit score and lower loan-to-value ratio can shift the numbers substantially in your favor. For example, a borrower with a credit score of 750 and loan-to-value ratio of less than 60% won’t be charged any additional cost for a cash-out loan; lenders believe he or she is no more likely to default on the loan than if doing a rate/term refi. 

Your loan may be a cash-out loan even if you don’t receive cash back. If you’re paying off credit cards, auto loans, or anything else that wasn’t originally part of your mortgage, the lender probably considers it a cash-out loan. If you’re consolidating two mortgages into one—and one was originally a cash-out loan—the new consolidated loan will also be classified as cash-out. 

One more reason to think twice about cash-outs: Doing a cash-out refinance can negatively affect your FICO score.

Although many personal finance experts would advise against stripping your home of its equity in a cash-out refinance, recent data shows that many Americans are choosing this loan type. Freddie Mac’s quarterly refinancing statistics demonstrated that in the fourth quarter of 2018 (released in March 2019), cash-out borrowers represented 83% of all refinance loans, the highest since the third quarter of 2007.

Source: Freddie Mac, Quarterly Refinance Report, 2018

Many of these refinances were not for rate reduction. The most common uses of the funds were paying bills or other debts, or doing home improvements.

Source: Freddie Mac, Quarterly Refinance Report, 2018

With the help of your mortgage broker, you may be to generate a little cash from your refinancing without it being considered a cash-out loan (and generating the extra fees that come with it). Basically, it works by taking advantage of the overlap of funds at the end of one loan and the beginning of another. It's a complicated process so pay close attention to how Fleming describes it:

“You are allowed to finance closing costs in a rate/term refi. Most lenders allow those closing costs to include prepaid expenses, such as prepaid interest, the unpaid accrued interest on your existing mortgage, the money necessary to pre-fund your escrow account, and even property taxes and insurance if you time it right.

“When you refinance, you pay the accrued interest on your existing mortgage up to the day it is paid off. You prepay your interest on your new loan from the day you fund until the first of the next month, and then you don’t make a payment the next month. Therefore, you have financed one month’s interest on your mortgage within the new loan.

“If you have an impound (or escrow) account to pay insurance and taxes with your existing mortgage, then your existing lender is holding some of your money—at least a couple of months of taxes and insurance each. When you refinance, your new lender will need some money on hand when your tax and insurance bills come due, so they will ask for some money up front. You can usually finance this.

“Then, after your loan closes, your old lender—who is holding some of your money—sends you a check equal to the balance of your escrow account when you paid off that loan. Cash!

“Also, because some of the fees change a little up until funding, most lenders allow a little bit of cushion—up to $2,000 in cash back in escrow without the loan being considered cash-out.

“What all this means is that you can finance ‘costs’ that aren’t really the cost of originating the loan but rather represent the cost of having the loan. On a $200,000 rate/term loan, it would be very feasible to generate about $4,000 in cash—the right circumstances, if it were structured carefully—without paying a cash-out penalty.”

Your job as the borrower is to have enough knowledge to discuss options with your lender. For most people, avoiding the added cost of a cash-out loan is the best financial move. If you have a specific reason for taking cash out of your home, a cash-out loan may be valuable, but remember that the extra amount of money you will pay in interest over the life of the loan can make it a bad idea.