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Cash Out Refinance Definition
Cash Out Refinance is taking a new mortgage on a property. It involves using the new mortgage to pay the existing mortgage, with any amount above the original mortgage going to the mortgagor. Basically, the mortgagor is cashing out some or all of the equity in the home and creating a new mortgage secured by the home.
A Little More on What is Cash Out Refinancing
When you need to borrow against your home’s equity, you can either choose to refinance and withdraw the net value or take a home equity line of credit, HELOC. HELOC and Cash Out Refinance are different in a number of ways including:
Refinancing pays your first mortgage; so, you’ll have a new mortgage which may have different terms. This new mortgage comes with a different repayment period, different interest, and a new amortization schedule different from your first mortgage.
In HELOC, you take an addition loan to your existing mortgage. This will be viewed as a second mortgage. The second mortgage does not repay the first. The second mortgage will have different terms from the first. If you have repaid the first mortgage in full, this second mortgage will act as your first.
In Cash Out refinance, you are given a lump sum when you get the loan. Here, the proceeds of the mortgage are used to pay off your first mortgage(s) including any associated costs and the remaining funds can be cashed out. .
In HELOC, you are allowed to withdraw money from your line of credit during the draw period which is normally ten years. During the draw period, you will make monthly payments which will pay the principal and interest. After the draw period ends, you can no longer withdraw money and you start the repayment period. You will have up to 20 years to repay the mortgage.
Cash-Out refinance is offered through a fixed rate or adjustable rate mortgage. You will be presented with both options and you choose which is affordable according to your situation.
In HELOC, the interest rate is variable and dependent on an index, the US Prime Rate as will be published in the Wall Street Journal. The interest rate will increase if the index goes up and will decrease if the index goes down. However, your lender can offer a fixed rate mortgage that allows you to have all the remaining or a portion of the remaining mortgage to a fixed rate loan. This option is offered by Bank of America.
Cash out refinancing incurs closing costs similar to your first mortgage, while a HELOC has no closing costs or has relatively small costs. Before you take either of the mortgages, talk to your lender and they will give you information on both mortgage options so you can choose the one that will suit your situation.
Benefits of Cash-Out Refinance
Low interest rates – Comparing this mortgage type to HELOC or home equity loan, HEL, cash out refinance often offers lower interest rates.
- Debt consolidation – You will no have two outstanding mortgages.
- Better credit history – It may be used to consolidate debt and improve your credit score.
- Tax Refunds – Mortgage interest rates are tax deductible. With a cash out refinance, you reduce your taxable income and can even get a big tax refund.
- Risk of Foreclosure – Your home is the collateral in any kind of mortgage. Increasing the debt owed increases the foreclosure risk.
- New Loan terms – You will have new terms for the cash-out refinance loan.
- Closing Costs – As with any refinance loan, you will have to pay closing costs that are between 3 and 6 percent of the principal amount.
- Private mortgage insurance will be needed if you take a mortgage about 80 percent of the value of your home. PMI costs between 0.05 and 1 percent of the loan amount every year.
References for Cash-Out Refinance
Academic Research on Cash Out Refinancing
- Structural change in the mortgage market and the propensity to refinance, Bennett, P., Peach, R., & Peristiani, S. (2001). Journal of Money, Credit and Banking, 955-975. This study looks at the reasons that people refinance. It observes that with technological advancements and the competition between lenders and the awareness of homeowners, refinancing has become common. The research concludes that interest rates and home equity contribute the most towards the refinancing decisions. It also notes that, most homeowners will not refinance their mortgages when the interest rates go up.
- The evolution of the subprime mortgage market, Chomsisengphet, S., & Pennington-Cross, A. (2006). Federal Reserve Bank of St. Louis Review. This study examines subprime lending and how it has influenced refinancing. It observes that subprime lending has created a number of products based on a borrower’s credit history, and down payment needs.
- Credit history and the performance of prime and nonprime mortgages, Pennington-Cross, A. (2003). The Journal of Real Estate Finance and Economics, 27(3), 279-301. This paper examines the characteristics of non prime mortgages. It observes that these mortgages have gained popularity but there is little known about them. It takes a sample of a 30-year fixed rate home purchase from 1995 to 1999. It shows that nonprime loans have substantially high interest rates compared to prime rates. Details further show that these loans default at higher levels and they have different risk characteristics compared to prime loans.
- The impact of homeowners’ housing wealth misestimation on consumption and saving decisions, Agarwal, S. (2007). Real Estate Economics, 35(2), 135-154. This study looks at how home owners overestimate house values by about 3.1 percent and how this overestimation affects their consumption and saving decisions. It shows that consumers who take cash out refinance to enhance their consumption are likely to overestimate or underestimate their house value. The paper concludes that underestimators will likely prepay their loans while overestimators will likely default.
- Getting at systemic risk via an agent-based model of the housing market, Geanakoplos, J., Axtell, R., Farmer, J. D., Howitt, P., Conlee, B., Goldstein, J., … & Yang, C. Y. (2012). American Economic Review, 102(3), 53-58. This paper, using individual data from Washington DC, constructs a model of agent based housing market. It builds this model following 20 years of success with agent based housing models.
- Subprime refinancing: Equity extraction and mortgage termination, Pennington‐Cross, A., & Chomsisengphet, S. (2007). Real Estate Economics, 35(2), 233-263. This article examines the choice of borrowers to extract wealth from housing in the high‐cost (subprime) segment of the mortgage market and assesses the prepayment and default performance of these cash‐out refinance loans relative to the rate of refinance loans. Consistent with survey evidence, the propensity to extract equity is sensitive to the relative interest rates of other forms of consumer debt. After the loan is originated, our results indicate that cash‐out refinances perform differently from non–cash‐out refinances. For example, cash‐outs are less likely to default or prepay, and the termination of cash‐outs is more sensitive to changing interest rates and house prices.
- Estimates of home mortgage originations, repayments, and debt on one-to-four-family residences, Greenspan, A., & Kennedy, J. E. (2005). This paper examines how the stopping of the gross mortgage flow system by the Department of Housing and Urban Development has affected the industry. It shows that there has been no attempt to reconstruct the gross flows. The paper has used a different approach to reconstruct the system and reconcile the changes mortgage debts.
- Refinance and the accumulation of home equity wealth, Nothaft, F. E., & Chang, Y. (2005). Building Assets Building Credit: Creating Wealth in Low-Income Communities, 71-102. This study looks at how refinance helps homeowners create wealth through refinance and the dangers that homeowners face when they refinance. It also looks at how, though building assets and wealth, homeowners build credit or delve deep into debt.
- Mortgage refinancing in 2001 and early 2002, Canner, G., Dynan, K., & Passmore, W. (2002). Fed. Res. Bull., 88, 469. This paper is an examination of the development of refinancing mortgages in 2001 and early 2002. During this period, there was little knowledge and homeowners did not understand why they needed to refinance. In early 2002, the number of homeowners refinancing increased significantly.
- Housing markets and economic growth: lessons from the US refinancing boom, Deep, A., & Domanski, D. (2002). BIS Quarterly Review, 37-45. This paper studies how refinancing has facilitated the growth of the housing market with more and more people buying homes. Refinancing has reduced number of defaulters and enhanced the economy of countries. The paper looks at the US in the face of increased cases of refinancing.
- Are housing prices, household debt, and growth sustainable?, Papadimitriou, D. B., Chilcote, E., & Zezza, G. (2006). There is increased borrowing from homeowners something that this paper attributes to rising home prices and lenders offering low interest rates. The paper shows that interest rates are outer balanced and the borrowing trends are not sustainable. Household spending is rising fast and the income growth is still low.
- Do borrowers make rational choices on points and refinancing?, Chang, Y., & Yavas, A. (2009). Real Estate Economics, 37(4), 635-658. This study shows that borrowers with points do not often refinance and when they do, they take longer before refinancing again. The study shows that borrowers with low/high refinancing costs are keen to get into mortgages with low-point/high-rate or high-point/lower-rate loans.