Is “cash-in” refinancing a smart move? In some cases it is, but homeowners might want to kick themselves later for doing it.
If you haven’t heard of cash-in refinancing, don’t feel bad. Until recently, it was a poor relation among refinancing options. Cash-in refinancing involves putting more money into the property to reduce the monthly payment. You could replace an old $300,000 loan with a new one for only $250,000 by coming up with an extra $50,000, for example.
According to Freddie Mac (Stock Quote: FRE), 22% of people refinancing the company’s loans in the quarter ended June 30 selected the cash-in option. That ties for the third highest quarterly rate since Freddie Mac started keeping records in 1985.
Most refinancings simply use a new loan to pay off the balance on the old one. The homeowner gets a lower interest rate, reducing the monthly payment.
Homeowners can also do “cash-out” refinancing, with a new loan for more than the balance on the old one. This has long been a popular way to convert equity in the home to cash. But many homeowners have been burned by cash-out refinancings done in the middle of the decade, as they now owe more than their homes are worth due to falling home prices. With home prices down, cash-out refinancings have fallen to their lowest level since they started keeping records 25 years ago, Freddie Mac says.
Some homeowners resort to cash-in deals in order to qualify for the new loan, which can create a problem if the loan balance exceeds 80% of the property’s current value. The loan-to-value ratio goes up if the property value falls significantly, since the decline in loan balance is slow over the years.
Other refinancers put cash in to reduce the balance, making the monthly payment even lower than it would be by simply cutting the interest rate. Use the Refinance Breakeven Calculator to calculate the benefits of refinancing.
The average 30-year fixed-rate mortgage currently charges 4.5%, according to the BankingMyWay survey. If the loan balance is reduced, the homeowner avoids interest charges on that sum, in effect earning a yield equal to the loan rate of 4.5%.
So is a 4.5% yield good enough? The homeowner might do better putting that cash into stocks, but would also risk losing money. The money could go into the bonds, but those too, have a risk if rising interest rates push prices down.
Since the return on the mortgage pay-down is guaranteed, an apples-to-apples comparison should look at risk-free alternatives like bank savings. The most generous bank savings is the five-year certificate of deposit, now averaging 1.9%, according to the BankingMyWay survey. That makes the 4.5% cash-in refinancing look like a good investment.
Keep in mind that extra money put in the mortgage is tied up for the long term, that is until the property is sold or a new cash-out loan is obtained. Before putting cash in the mortgage, think about how else you could use that money in the coming years.
Also note that today’s bank savings rates are extraordinarily low. If the economy strengthens in the next few years, savings yields could rise. The 4.5% you’d earn paying down mortgage principal might not look so generous later. And after all, six-month CDs paid more than 5% as recently as 2007.
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