(Updated January 2015)
Time flies when your kids are growing up, doesn't it? Your son or daughter is in high school now, fast approaching college, and tuition expenses are rising quicker than the balance in your college savings fund.
Before you tell your rising scholar that it's time to join the working world, consider a cash-out mortgage refinance. The reasonable refinance rates available can help to fund that critical college education.
Understanding the Cash-Out Mortgage Refinance
Refinancing a mortgage means replacing your old mortgage with a new one. People often do this in order to get a lower interest rate than they're currently paying, or to shorten the loan term in order to pay it off faster - such as refinancing into a 15-year fixed-rate mortgage when you have 20 years remaining on a 30-year loan.
What you can also do, however, is use refinancing as an opportunity to borrow money by taking out a new mortgage that is larger than the one you have now. If, for example, you owe $150,000 on your mortgage, but your house is worth $250,000, you could raise $50,000 cash by refinancing the $150,000 mortgage with a $200,000 loan. This is called a cash-out refinance.
Things To Consider
The three factors determining how much cash is available to you when you refinance your mortgage are your equity, your income, and current refinance rates.
- Equity. Many homeowners have built up sizeable equity, particularly in recent years as home values have soared. The more equity you have, the more cash is available to you through a refinance. Borrowers will generally want you to have at least 20 percent equity remaining after refinancing. You may be able to go lower than 20 percent in some cases, but that would require that you pay for mortgage insurance, which would raise your cost of borrowing.
- Income. Your monthly cash flow might put limits on how much money you can borrow. Consider a longer loan term, i.e., 30 years instead of 15, if cash flow is tight. On the flip side, you may have a larger income now than when you first purchased your home. If so, you might be interested in a shorter term to save money on interest payments and get the mortgage paid off sooner.
- Interest rates. Depending on the age of your existing mortgage, a refinance might lock you into a lower interest rate than you were paying before. If rates are higher, consider the tax benefits of the interest that you pay on your mortgage when deciding what you can afford to borrow.
One of the great things about a cash-out refinance compared to other types of loans is that the interest is tax-deductible, assuming that you itemize. Mortgage interest rates also tend to be lower than on other types of loans, particularly non-secured ones.
About closing costs and home equity loans
One downside of a cash-out refinance are the origination fees. Origination fees are charged as a percentage of the loan amount, so in the example above, you'd be paying a percentage of $200,000 in closing costs - often 2-6 percent of that amount.
So you could end up paying $4,000-$12,000 in fees to borrow $50,000. This is why it's important for the other elements of a cash-out refinance to work in order for it to make good financial sense. For example, it could well be worth it to pay that $4,000-$12,000 if it will save you $30,000-$40,000 in interest over the life of the loan.
An alternative to a cash-out refinance that you might consider is a home equity loan. The rates might not be as good as on a refinance, but the closing costs are less because you're only borrowing what you need. Another possibility is a home equity line of credit (HELOC), which allows you to borrow in irregular amounts as you need it, up to a certain limit. This can be a good type of loan for things like college expenses where there will be periodic expenditures over time - and HELOCs commonly have no closing costs, though they typically do charge annual fees.
Just like with a cash-out refinance, however, the interest you pay on a home equity loan or line of credit is tax deductable, because they're considered a second mortgage.
A mortgage refinance or home equity loan might be a necessary step towards giving your rising scholar every advantage possible. Now that you know the basics, you can research the specifics with a few different lenders to compare terms and understand your options.