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Cash-Out Loans Can Cost a Pretty Penny

Borrowers who withdraw cash when they refinance are viewed as riskier than those who don’t, because the cash withdrawal indicates possible financial distress — and that perception can raise a borrower’s costs.

The rate on cash-out deals is higher than on no-cash deals that are otherwise identical. The price difference is particularly large when the borrower’s credit score is low, an illustration of “risk layering.”

Note that refinancing borrowers can increase their loan balance by enough to cover their settlement costs without the loan being classified as “cash-out.” The borrower must literally walk away with cash for the transaction to be “cash-out.”

Whether or not cash is withdrawn is entirely within the borrower’s discretion. But many use the discretion unwisely because they underestimate the cost of the money they take out of the refinance. They view the cost as the rate on the new mortgage, ignoring the higher cost on the existing loan balance.

For example, consider the borrower with a credit score of 620 who could refinance a $240,000 balance at 4.14 percent but instead refinances $254,000 at 4.88 percent in order to get $14,000 in cash. The interest cost of the $14,000 is not 4.88 percent because this ignores the higher rate the borrower must pay on the $240,000 balance. If this additional cost is added in, as it should be, the borrower is paying 15.24 percent rather than 4.88 percent. At that rate, there could be much better options for raising cash.

Note that a cash-out deal raises the ratio of loan amount to property value, or LTV. If the borrower must pay a higher mortgage insurance premium at the new LTV, the cost of the cash taken out would be raised even more.

The mortgage interest rate is not usually affected by the LTV, but if the ratio is above 80 percent, the borrower must pay for mortgage insurance.