The "cash-out refi vs. home equity loan" debate used to mainly hinge on the interest rate: if you could improve on your current interest rate, you should opt for a cash-out refinance. Today, however, pricing changes have altered that equation. Home equity loans may actually be the cheaper alternative.
Before the housing crisis, if you needed some cash, the choice between a home equity loan and a cash-out refinance was pretty straightforward: if you could get a better interest rate than the one on your current loan, the cash-out refinance was the clear winner. However, that was before the advent of risk-based pricing models in mortgage lending. In the past, loan approval was pretty much a pass/fail process. But now, mortgage lenders like to separate the perfect applicants from the good applicants, and the good applicants pay more -- in some cases, a lot more. And there really isn't any way to take cash out of your property and be a perfect applicant.
Cash-out Refis Are More Expensive
A look at Fannie Mae's Loan Level Pricing Adjustment (LLPA) matrix tells the story. Cash-out is expensive. For example, let's say you have a credit score of 679 and want to get a cash-out refinance to 80% of your home's value, you face the following surcharges, for a total of 4.25%:
- Adverse market delivery charge: 0.25%
- Credit score < 740: 2.5%
- Cash-out refi to 80% loan-to-value: 1.5%
Is 4.25 points unreasonable? That depends on how much you can improve your interest rate and how much cash you need. If your current interest rate is 5.75% and you need $15,000 cash, this refi is probably not worth it if your new rate is 5%. Here's an example:
- Current interest rate: 5.75%
- New interest rate: 5.00%
- Current loan amount: $385,000
- Desired cash amount: $15,000
- New loan amount: $400,000
- Cost: 1 point for loan origination plus $3,000 in title and escrow fees plus 4.25% LLPA= $24,000
Essentially, you're paying $24,000 to borrow $15,000! But you are lowering your interest rate, so that needs to be accounted for. You can see the annual percentage rate (a calculation which has some limitations, but can be helpful) by putting the costs into HSH.com's APR calculator. The APR comes up as 5.52%. Not bad, since home equity loan interest rates are about 2.25% higher, and 5.52% is still less than the 5.75% you were paying before, right?
Yet there are other ways to look at this. Those costs are all paid upfront. The difference between the payment on a $400,000 loan at 5.75% and one at 5% is $187 a month. It would take almost 11 years for your monthly savings to recoup the $24,000 you spent to refi. But that's not the only thing to consider. Annual percentage rate (APR) calculations are flawed because they work on the assumption that you keep the loan the entire 30 years (or however long your mortgage term is). What happens to the APR if you refinance the mortgage or sell the property in 10 years? The answer: the APR spikes to 6.2%! Why pay all that money to refinance to a more expensive loan?
What Does a Home Equity Loan Cost?
Almost nothing. Origination fees come to a few hundred dollars, and many mortgage lenders might even waive them when you close on your loan. Let's say you are offered a $15,000 home equity loan at 8% and zero closing costs. A 10-year, $15,000 loan at 8% would have a monthly payment of $181.99 a month. The amount of interest you would pay over the 10-year term equals $6,838.97.
One Disadvantage of Home Equity Loans
There is one disadvantage to consider -- one that wouldn't have come up before the foreclosure crisis. Borrowers who end up needing mortgage modifications have experienced a great deal more trouble getting them when they have a second mortgage against their properties. Many have ended up in foreclosure because the second mortgage holder refused to surrender its claims. So if you think you might possibly end up at the mortgage modification bargaining table, avoid bringing an extra lender into the mix.
Cash-Out Is About More than the Best Mortgage Rates
When you're looking at a cash-out refinance versus a home equity loan or line of credit, there's a lot more to it than getting the best interest rate. Take all the costs into account when making your decision.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.