Beware the Cash-Out Re-Fi

November 28, 2008 by  
Filed under Loans and Borrowing

This has been a good news week for homeowners looking to re-finance their mortgage loan into a lower rate.  Mortgage interest rates fell sharply this week following more rescue actions by the government.  The average interest rate for a fixed 30-year mortgage loan dropped to under 6%, a seven week low.   Mortgage loan re-financing activity has already picked up.   Unfortunately, re-financing a mortgage loan also creates a substantial risk that the borrower will end up with a larger loan balance. 

Mortgage refinance opportunities are often advertised that “no cash” is required to close the new loan or “no out of pocket closing costs.”   The lender uses such misleading come-ons to attract customers.  Some customers naively believe that “no cash needed to close” or similar language means that there are no closing costs.  Not until closing (or maybe never) do they realize that there are, in fact, several thousands of dollars in closing costs.  It’s just that these closing costs are paid from loan proceeds and therefore added to the principal balance that is owed.   That is not a smart thing to do for many borrowers because the interest on the added principal can wipe out the benefit of the re-finance, depending on how long the borrower owns the house.

Even more risky are “cash-out” re-financings where the lender offers to increase the loan amount by $5000-$20,000 or more, thereby putting this extra cash into the pockets of the borrower to spend.  Too many homeowners wrongly see this as “found money” and give in to the temptation.  They do not stop to calculate how much they will actually be paying for this “found money” over the life of the loan.

The hard truth is that taking cash out of a re-finance transaction is rarely a good idea and often defeats the purpose and benefit in securing the lower interest rate.  A mortgage loan re-finance should not be viewed as an opportunity to increase your overall debt load.

Mr. ToughMoneyLove suggests that mortgage re-financing should be focused on reducing the term of the loan and consequently lowering the total interest paid.  In other words, if you can shorten the amortization term of your loan from 30 years to 15 years while keeping the before and after monthly payments close (because of the lowered interest rate), that is a solid reason to go for the re-finance.

If you want to run some re-finance comparison numbers yourself, Bankrate.com has a re-finance calculator that can help you.

So take advantage of this interest rate gift that the government has provided.  But if you decide to re-finance, please resist the temptation to take cash out of the deal.  That new kitchen or exotic vacation can wait until better economic times are upon us. 


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Comments

6 Responses to “Beware the Cash-Out Re-Fi”
  1. Pulling out a bit of cash during a re-fi can be a very tempting option for many people, and banks are more than happy to push this option. One bank here uses the tagline “You’ve got more money than you think! Let us show you how!” or something along those lines.

    I’ve got a number of family members who have recent bought all kinds of fun things (new kitchen, cottage, motorcycle- you know, real necessities) despite often complaining about how little money they have. When I gently ask what bank they robbed, they tell me they took out some cash when they refinanced. It’s as simple as that! Even more troubling is that some of these people make a regular habit of this, doing it every few years.

    My goal is to get rid of my mortgage ASAP, not keep upping the amount to finance new toys. Apparently, that makes me “cheap”.

  2. Like all debt, the cash out refi can be dangerous, but can also be worthwhile depending on what it is used for. If you pull out money in order to start a business or invest in another property (if the numbers add up and you can afford it) then it might be a good move. However, I somehow suspect that the bulk of cash out refis from the past decade were not used all that responsibly.

  3. @MGL: If this market stays flat for years (which is a distinct possibilty) you will be quite content with the return on paying off your mortgage. That’s what I am counting on.

    @RDS: If a borrower has enough equity to pull out cash to start a business or invest in another property, wouldn’t it make more sense to do a HELOC?

  4. Miranda says:

    Ah, the cash-out re-fi. That’s one of the many reasons we’re where we are at right now. Using homes (that have fallen in value) to better participate in consumerism. Especially now, a cash-out re-fi can result in negative equity as home values continue to fall. And that’s not good for your finances at all. It’s important to remember that mortgage is debt. It may be considered “good” debt, but it is debt nonetheless and should be paid off as quickly as possible.

  5. Excellent advice. The cash-out re-fi is so tempting to so many. I personally know of several people who did this to pay off credit card debt. Within a year or two these people had charged their cards right back up again. Not a great plan!

  6. Simply40’s: Wouldn’t be nice if a lender could force a borrower to surrender their credit cards as part of the re-fi deal?

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