Cash out refinance is a term that applies to the process of refinancing a mortgage on a house where the owner has accrued substantial equity. That has happened to tens of thousands of homeowners in California over the last five years due to the steep run-up in housing values. One of the ways of converting that equity into cash is to take out a second mortgage on the home. Another method is to take out a new loan in California with more attractive terms than the old one, and borrow more than you owe on the house.
That is the process of cash out refinancing. Refinancing any home is an expensive proposition, because you are paying all of the closing costs that you encountered on your mortgage the first time around. In addition, your first mortgage may have a prepayment penalty that adds to the cost. It is critical to carefully analyze the value of cash out refinancing – it can often be the case that you are paying dearly for the cash you are extracting from your equity.
It’s important to consider all of the costs involved in cash out refinancing. A new mortgage probably means a new thirty-year payoff period on your home, so you are extending the period of debt. It you are getting a better interest rate on your cash out refinance mortgage, that’s a positive step but it will reduce your tax deduction as a percentage of your mortgage payment. If your new interest rate isn’t quite as good as the rate on the old mortgage, you will be raising the level of your tax deduction – but you have to be in the right tax bracket to make that worthwhile.
Cash out refinancing that takes your debt on the house beyond 80% of valuation may lead to a new requirement of mortgage insurance. That’s going to add to your monthly payment as well. So it is important to chart the added expenses of a new mortgage in order to determine the true cost of the cash you are extracting from your equity.
The comparison most people make is between the choice of a cash out refinance – that is, a whole new mortgage – and the option of a second mortgage. Once again, the issues are current versus former interest rates, closing costs (much lower on a second mortgage) and extending the life of your primary mortgage. Finally, cash out refinancing is only going to make sense if you plan to remain in the home for the foreseeable future. The cost of a new mortgage does not make sense otherwise.