The cash-out refinance has rarely looked so good

Remember back when you refinanced your home mortgage to get a lower interest rate and pay less every month?
By: Kenneth R. Harney: Los Angeles Times
How quaint. Now the rage is refinancing into a higher interest rate while pulling out cash.

Almost nine out of 10 homeowners who refinanced during the second quarter "cashed out" additional money — often tens of thousands of dollars and more — according to mortgage investment giant Freddie Mac. The 88% cash-out refi rate was close to the all-time record and could surpass it later this year.

Meanwhile, the typical refinancer hasn't been scouring the market for an interest rate lower than his or her existing first mortgage. To the contrary, according to Freddie Mac, most refinancers are opting for larger replacement first mortgages with rates averaging about one-half of a percentage point higher than on their old loan.

Cash-outs may be booming, but they are not new. They've existed for years as a financial tool to extract equity and convert it to immediately spendable money. During the refi boom years of 2003 and 2004, for example, anywhere from a third to half of all refinancers pulled out additional cash. However, the overwhelming majority of borrowers during that period chose traditional rate-reduction replacement mortgages in which the new balance approximated the old and the new monthly payment was lower than the old.

Scroll ahead to mid-2006: Short-term interest rates no longer hover near 4%. Thirty-year fixed-rate first mortgages no longer are in the 5% range. The prime rate is 8.25% and could move higher. Standard 30-year mortgage rates are nudging 7%. Home-equity credit lines are slumping as their adjustable rates — typically set one or more points above the bank prime — start racking up bigger monthly costs.

Now consider the near-record pace of cash-out refis: Say you need $40,000 to $100,000 for home improvement, a down payment on a vacation property or to consolidate high-cost consumer credit debts. Say you also have lots more than $100,000 sitting untouched in home equity. Rather than signing up for a home-equity credit line tied to a jumpy and unpredictable prime rate plus 1%, you instead opt for a fixed-rate cash-out refi.

In effect, you trade in your existing first mortgage — say it's at 6.25% — for a replacement at 6.75%. Plus you pull out the money you need and add it to the principal balance of the new loan. Yes, your monthly payment will be higher than you were paying on the old loan, and yes, you'll have transaction costs, which you may be able to roll into the new loan amount. And yes, your total first mortgage debt may be significantly higher than it was.

But then again, would you be happier with a $100,000 credit line with a floating rate potentially heading for double digits?

Amy Crews Cutts, Freddie Mac's deputy chief economist, says another factor at work in the big shift to cash-out refis may be the estimated $500 billion in adjustable-rate first mortgages that will experience rate "resets" this year, plus another $650 billion in second mortgages and equity credit lines that will adjust upward.

Many homeowners want out of these mortgages — especially those with 40% and 50% payment increases at the first reset. Refinancing into standard fixed-rate loans suddenly looks attractive. And if homeowners can pull out some cash in the process, that's fine, says Cutts, because "many people see that their real estate has been one of the only things making money for them during the past few years."

Another key to the cash-out refi boom, according to Cutts: "Borrowers have developed new ways of thinking about their home mortgages" and increasingly see them as resources — not just debt loads — to be used to achieve financial objectives.

Should you consider a cash-out? Not unless you really need the money; you don't want to play roulette with an adjustable-rate equity line; you want to lock in your mortgage debt at a relatively low long-term fixed rate. Check out fixed-rate second mortgages as well.