When you need a significant amount of cash for some expense such as college tuition for your kids, several credit alternatives are available to you, including a loan or a home equity line of credit (HELOC). A growing number of homeowners are taking advantage of another alternative — cash-out refinancing.
According to data from Black Knight Financial Services, there were 68% more cash-out financing deals in the second quarter compared to the same period in 2014, representing the largest number of such refinance agreements in five years. Cash-out refinancing is on the rise because two important factors are currently favorable to the practice. Mortgage rates are still staying stubbornly low, and home prices are rising rapidly.
In cash-out refinancing, you are effectively taking out a mortgage for more than you currently owe on your home and pocketing the difference. That is sensible when you can improve significantly on the interest rate you owe and fees and other closing costs do not consume too much of the difference. When home values are increasing, your loan-to-value (LTV) ratio is decreasing by definition — thus making you a lower payback risk for banks and potentially allowing you to receive an even better interest rate.
Over the past year, homeowners have enjoyed a nearly $1 trillion increase in their collective equity, and they are now looking at putting it to use. The current average for the cash-out portion of a refinance is $65,000, approximately what it was in 2006 as housing was nearing a peak and people were treating their homes as ATMs. The areas with the greatest increase in home prices (and more people harmed by the housing crisis) are leading the charge, including California with 30% of all cash-out refinances and Texas with 7%.
Are people returning to the carefree housing attitudes of ten years ago? Not really. The number of cash-out refinances is increasing but is still 80% below the 2005 peak and the amount of the home leveraged is down to 68% on average — in other words, the average LTV after cash-out refinancing is 68%. Fewer people are cashing in equity on their home compared to ten years ago, and those who are cashing in equity do not extend their debts as much as they used to.
Is a cash-out refinance right for you? That depends on the available interest rate and the terms of your existing mortgage, how much equity you have built up relative to the amount of cash that you need, and what you plan to do with the cash.
Consider your alternatives first. For example, in the case of college tuition, are there scholarship alternatives, grants, or work-study programs that can prevent or decrease the overall student debt? Can a different college provide the same level of education while making more sense economically? If you decide it is worth the use of the cash, then it is simply a matter of comparing interest rates and payments with a particular refinancing rate. Online mortgage calculators can help you make a cost-benefit analysis and find a target interest rate that makes it worthwhile for you to proceed.
Other home-equity based alternatives are also available to you, such as a HELOC or a reverse mortgage. With a HELOC, you are effectively taking a second mortgage out on some portion of the equity in your home. When rates are higher than your original mortgage, you can keep the lower interest rate on the bulk of your mortgage while subjecting the lesser HELOC amount to the higher rate. In a reverse mortgage, you are effectively selling your home back to the bank a bit at a time — fine if you don't plan to leave a home to your heirs and you are not likely to "outlive your equity," or use up your home equity before you pass away.
Do your own calculations to decide which path is right for you, but if you decide on cash-out refinancing, you should probably act quickly. The Federal Reserve will eventually have to raise interest rates, and mortgage rates will follow. The current combination of interest rates and home valuation trends may be about as good as it gets.