Refinance, Cashout Refinance, or Stay the Course - which is best for you and why?
Before jumping in, it is best to get a baseline understanding of what we are referring to when we say "refinance". A "refinance" is a restructuring of terms for an existing debt. Typically, the terms that we are referring to which are to be restructured are the number of payments, the interest rate, and/or the amount owed, depending on the type of refinance that you decide to do.
Over the last 2 years in the US, we've seen overall interest rates dip lower than they ever have before. This means that the cost of borrowing money is significantly cheaper than it ever has been. For example, if a home buyer were to get a mortgage of $500,000 to be paid over 30 years at an interest rate of 5% (APR), the total amount of money paid over the life of the loan would be equal to $966,278.92 with a monthly payment of $2,684.11. If the interest rate dropped from 5% to 3%, for the same loan of $500,000 paid over 30 years, the borrower would owe $758,887.26 and the monthly payments would go down to $2,108.02. Wow!! That's an overall savings of $207,391 over 30 years and a monthly savings of $576.09. See how a change in interest of 2% can have a significant effect on the cost of borrowing money? These rock bottom rates have greatly contributed to the increase in home buying demand over the last 2 years.
On the other hand, a cashout refinance can be a critical tool for investors! Rather than refinancing with the intention of saving money, a cashout refinance is done to tap into the equity of a home in exchange for cash in hand, which can then be used to buy another investment property!
For those in a hurry, feel free to get right to it by clicking on the videos below!
Let's start with a traditional refinance. A traditional refinance is a restructuring of existing debt on a house. It's simply "refinancing" what you owe on the property. Sometimes borrowers will refinance their existing debt to either reduce their monthly expenses, or to accelerate their debt payoff.
The most popular reason to refinance your existing debt is to reduce your monthly expenses. If the national interest rates have fallen since you first purchased your home (referring to the example at the beginning of this post), you might be able to refinance using lower interest rates, while still holding the number of payments that you have left on your mortgage, and thus, save money because your cost of borrowing that money (interest rate) is less. Additionally, some borrowers will further capitalize on their opportunity to reduce their monthly payments as they will take their existing debt and not only leverage a lower interest rate, but they will initiate a new 30 year payoff period. A lower interest rate, spread over more payment periods will greatly reduce your monthly expenses!
What's the catch?
Well.... reducing your monthly expenses is great, however, if you choose to restructure the payment timeline (maybe you had 21 year left and you restructure the payment out another 30 years), it will take you that much longer to pay off your home. For some, that is perfectly fine, for others, it may not align with their goal of one day paying off their mortgage and owning their home outright.
Are there closing costs associated with a refinance?
YES! The bank and the broker need to get paid for their services. Usually it will cost $5,000 - $8,000 to refinance your existing debt. (Pro-tip! These closing costs can usually get bundled into the balance of the loan so you have no out of pocket expenses when you refinance).
Next, let's chat about what it means to "cashout" refinance. A cashout refinance is also a restructuring of your debt, however, you as the borrower are also accessing your equity! Remember, equity is the difference between what you owe on your home and what the home is worth (typically an appraiser conducts an appraisal to deduce the market value of your home).
A cashout refinance is based on the value of the home, rather than the debt that you have left to pay off. Typically, a lender will allow you to cashout refinance up to 80% LTV (loan to value). So... if your home is worth $500,000 and you owe $300,000, the lender will cashout refinance your loan up to $400,000. They will then subtract and hold what you originally owed, in this case $300,000, and you as the borrower are left with the remaining $100,000 in cash!
Many real estate investors will use this strategy to build their capital so they can continue to buy homes and scale their portfolio. In fact, we are actually in the process of doing this now for two of our long term rentals in Chattanooga, TN!
What's the Catch?
Opposite from a traditional refinance, your monthly expenses will typically increase, because you've now increased the amount of money that you owe on the home. In our example above, you've increased what you owe by $100,000, which unless you sell your home, this money needs to be paid back. To make the increase in expenses manageable, the lender will usually structure the payments to last 30 years from the date of restructuring.
I typically advocate for the cashout refinance strategy ONLY if your intention is to use that money to invest and buy cashflowing properties. The cashflow from those properties along with the value appreciation will typically exceed the increase in monthly expenses in your home as a result of the cashout refinance.
Are there closing costs associated with a cashout refinance?
Yes! Much like the traditional refinance, you will incure closing costs, typically $5,000 - $8,000. However, I typically advise clients to have these closing costs bundled into the loan so the borrower does not have to pay any money at the time of closing.