Cash-out vs. Rate-and-Term Mortgage Refinancing Loans

When refinancing a mortgage, you can refinance your existing loan by using a rate-and-term refinance to get a lower interest rate, change the loan term or length, or change the loan type. You can also do a cash-out refinance, which exchanges a portion of your home's equity for cash.

Homeowners might withdraw equity for cash to pay down debts, do home repairs, or pay for their child's college education. However, whether you choose a rate-and-term refinance or a cash-out refinance, it's important to understand how these two products can affect your finances.

The Basics of Mortgage Refinancing

When you refinance your mortgage loan, you're replacing your existing mortgage with a new loan or consolidating a pair of mortgages into a single loan. The adage, out with the old and in with the new, applies to mortgage refinancing since the old loan is paid off, and a new one replaces it.

Mortgage Interest Rates

One of the most common reasons to refinance is a drop in mortgage interest rates. Rates tend to fluctuate with the ebbs and flows of supply and demand for homes and mortgages. However, during recessions, rates can drop significantly.

In June 2007, the 30-year fixed-rate mortgage rate was above 6.50%. Following the financial crisis and the Great Recession from 2007-2009, rates fell to roughly 4.70% by Dec. 2009. By Dec. 2012, the 30-year fixed mortgage rate was slashed nearly in half from five years earlier to 3.35%.

By 2018, mortgage rates had risen to 4.80% but eventually declined, particularly following the COVID-19 pandemic. By Dec. 2020, the 30-year fixed rate was just over 2.60%.

The New Mortgage Term and Product

Let's say you have a 30-year fixed-rate mortgage loan that you paid for the past 10 years, meaning you have 20 years remaining on the loan. If rates drop significantly and you do a rate-and-term refinance, you could book a new 20-year fixed-rate loan to replace the existing mortgage but at the much lower rate, lowering your monthly payment.

You could also extend the term of the loan back to 30 years at the new rate, lowering your monthly payment even more. However, it would take longer to pay off the loan, and you would have an extra 10 years of mortgage interest cost, albeit at a lower rate.

When rates are moving higher, refinancing can offer a chance to convert an adjustable-rate mortgage into a fixed-rate one to lock in lower-interest payments before rates climb even higher. However, it's often challenging to forecast the future direction of interest rates, even for the most seasoned economists. Please compare rates between mortgage lenders to ensure you get the best available rate.

Cash-out vs. Rate-and-Term Refi

The most straightforward option is a rate-and-term refinance. No money changes hands in this case, except for the fees associated with the loan. The mortgage's size remains the same; you trade your current mortgage terms for newer (presumably better) terms.

In contrast, in a cash-out refinance loan, the new mortgage is bigger than the old one. Along with new loan terms, you’re also advanced money—effectively taking equity out of your home in the form of cash.

Cash-out Loans Can Be Pricier

Cash-out loans may come with tougher terms. How much depends on the amount of equity you have built up in your home and your credit score.

For example, if your FICO score is 700, your loan-to-value ratio is 76%, and the loan is considered cash-out, the lender might add 0.750 basis points to the up-front cost of the loan. If the loan amount is $200,000, the lender would add $1,500 to the cost (though every lender is different). Alternatively, you could pay a higher interest rate—0.125% to 0.250% more, depending on market conditions.

As a result, it's important to consider that a cash-out refinance can negatively affect your FICO score.

Special Considerations on Cash-Out Loans

In certain circumstances, cash-out loans may not have tougher terms. A higher credit score and lower loan-to-value ratio can shift the numbers substantially in your favor. If you have a credit score of 750 and a loan-to-value ratio of less than 60%, for example, you may not be charged any additional cost for a cash-out loan if the lender believes that you are no more likely to default than if you did a rate-and-term refi.

Your loan may be a cash-out loan, even if you don’t receive any cash. If you’re paying off credit cards, auto loans, or anything else not originally part of your mortgage, the lender may consider it a cash-out loan. If you’re consolidating two mortgages into one—and one was originally a cash-out loan—the new consolidated loan may also be classified as a cash-out. 

An Interesting Mortgage-Refinancing Loophole

With the help of your mortgage broker, you may be able to generate a little cash from your refinancing without it being considered a cash-out loan (and generating the extra fees that come with it).

Basically, it works by taking advantage of the overlap of funds at the end of one loan and the beginning of another. If you consider this option, it may be wise to consult with a mortgage expert because it is a complicated process that will affect any escrow accounts.

The Bottom Line

Before refinancing, it's important to discuss your financial options with your mortgage lender. You can refinance your existing mortgage using a rate-and-term refinance, which usually lowers the interest rate. You can also change the loan term or loan type. If you have a specific reason for taking cash out of your home, a cash-out loan may be valuable. However, the amount of money added to the loan balance will be charged interest over the life of the loan, which can make a cash-out refinance more costly.