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Should You Use a Cash-Out Refinance or a Separate Loan?

Should You Use a Cash-Out Refinance or a Separate Loan?

Michael Jensen, Mortgage and Finance Guru
, Mortgage and Finance Guru

    In addition to a cash-out refinance, borrowers also have the option of arranging a separate loan to finance a major purchase.  In many situations it may not make financial sense to do a cash-out refinance to pay for significant items such as a new car, college tuition or home renovations.  Depending on the interest rate and term for your existing mortgage and the separate loan as compared to the cash-out refinance, you may end up paying much more in total interest if you refinance.

    This is because by doing a cash-out refinance you are effectively replacing the separate loan, which is usually shorter in length (for example, the length of a car loan is typically five-to-seven years) with a new mortgage, which is longer in length -- typically 15-to-30 years. You are also extending the length of your original mortgage. For example if you are ten years into a 30 year mortgage and you refinance that loan with a new 30 year mortgage, it effectively takes you 40 years to pay off your original mortgage. The longer the length of a loan, the more interest expense you pay over the life of the loan.

  • CalculatorUse our CASH-OUT REFINANCE CALCULATOR to determine how much money you can take out of your home
  • The key factors that determine whether you should use a cash-out refinance or keep your current mortgage and finance a major purchase with a separate loan are the interest rates and terms for the mortgages and the separate loan as well as the combined monthly payments for the loans.  Even in cases where a refinanced mortgage rate is lower than the interest rate for a separate loan (for example the new mortgage rate is lower than the interest rate on a car loan), you can end up paying more in total interest expense over the life of the refinanced mortgage if the term of the mortgage is longer than the separate loan.  Additionally, it is important to highlight that the mortgage rate on a cash-out refinance is usually higher than the interest rate for a standard refinance.

    There may be a trade-off between having a lower monthly payment for a set number of years and paying more in total interest over the life of the new mortgage.  For example, if you do a cash-out refinance you may have a lower monthly payment, at least initially, than if you kept your existing mortgage in place and obtained a separate five year car loan.  In the long term, however, if you obtained a separate car loan, the combined debt payments for your mortgage and car loan would decrease in five years after you paid off the car loan.

  • Great Mortgage IdeaBecause most mortgages have longer terms than other types of loans, a cash-out refinance can cost thousands of dollars more in total interest expense than a separate loan even if the loan has a higher interest rate
  • The total interest expense would also be much lower because you did not extend finance your car purchase with a new mortgage, which effectively would have turned a five year car loan into a 30 year loan, significantly increasing your total interest expense. Even if loans with shorter terms such as student, car and personal loans have a higher interest rate, they may save you money in the long run as compared to a 30 year mortgage.

    In an ideal scenario a cash-out refinance enables you to reduce your mortgage rate or length, allowing you to reduce your monthly payment and total interest expense and access the equity in your home. Otherwise, it may make more sense and save you money over the long term to keep your current mortgage in place and obtain separate loan.

    The table below compares refinance loan terms for lenders in your area. We recommend that you request refinance proposals from multiple lenders in the table to find the best terms including the lowest mortgage rate and fees. Shopping multiple lenders and comparing proposals is the best way to save money when you refinance.

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    Current Refinance Mortgage Rates as of January 23, 2019
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  • Example: Comparing a Cash-Out Refinance to a Separate Financing
  • The two examples below compare a cash-out refinance to keeping you current mortgage in place and obtaining a separate $50,000 college tuition loan with a 7.0% interest rate:

    • Example #1: In the first example the borrower is ten years into his or her original $300,000, 30 year fixed rate mortgage with an interest rate of 5.0%.  We compare the borrower keeping his or her original mortgage and getting a separate college tuition loan to a $300,000 cash-out refinance with a 5.0% interest rate -- the same interest rate as the original mortgage. 
    • Example #2: In the second example the borrower is also ten years into his or her original $300,000, 30 year fixed rate mortgage with a higher mortgage rate of 7.0%.  We compare the borrower keeping his or her original mortgage and getting a separate college tuition loan to a $300,000 cash-out refinance with a 4.0% rate -- lower than the original mortgage.

    In the first example, the borrower needs to decide if the lower monthly payment for the first ten years of the refinanced mortgage is more important than paying $117,600 more in total interest expense over the life of the new mortgage as compared to not refinancing and obtaining a separate college tuition loan.

    In the second example, it makes financial sense for the borrower to do a cash-out refinance.  Refinancing a mortgage with a significantly lower mortgage rate enables the borrower to lower his or her monthly mortgage payment and reduce total interest expense over the life of the mortgage by more than $25,000 as compared to not refinancing and obtaining a separate college tuition loan.

    Review the summaries below each example to understand the importance of mortgage rate and loan length when evaluating a cash-out refinance as compared to keeping your current mortgage in place and obtaining a separate loan.

  • Example #1:
    Cash-Out Refinance With Same Mortgage Interest Rate

    Original
    Mortgage
    Tuition Loan Total Cash Out Refinancing
    Amount of Original
    Mortgage
    $300,000 $50,000 Not applicable $300,000
    Term 30 10 Not applicable 30
    Years into Mortgage 10 Not applicable Not applicable Not applicable
    Current Principal Balance $244,000 $50,000 $294,000 $300,000
    Interest Rate 5.0% 7.0% Not applicable 5.0%
    Monthly Payment $1,610 $580 $2,190 $1,610
    Total Interest Expense $279,600 $19,600 $299,200 $416,800

    Savings / (Cost) Compared to Not Refinancing

    Monthly Mortgage and Tuition Loan Payment $580
    Total Interest Expense Over the Life of the Mortgage ($117,600)

    Example #2:
    Cash-Out Refinance With Lower Mortgage Interest Rate

    Original
    Mortgage
    Tuition Loan Total Cash Out Refinancing
    Amount of Original
    Mortgage
    $300,000 $50,000 Not applicable $300,000
    Term 30 10 Not applicable 30
    Years into Mortgage 10 Not applicable Not applicable Not applicable
    Current Principal Balance $257,437 $50,000 $307,437 $300,000
    Interest Rate 7.0% 7.0% Not applicable 4.0%
    Monthly Payment $1,996 $580 $2,576 $1,432
    Total Interest Expense $418,560 $19,600 $438,160 $412,477

    Savings / (Cost) Compared to Not Refinancing

    Monthly Mortgage and Tuition Loan Payment $1,144
    Total Interest Expense Over the Life of the Mortgage $25,683
    • The borrower refinances the original mortgage into a new 30 year fixed rate mortgage at the same interest rate of 5.0%
    • By refinancing the borrower saves $580 per month for the first ten years of the refinanced mortgage (because the borrower is not making a monthly payment on a separate college tuition loan) and then makes the same monthly mortgage payment as the original mortgage for the following twenty years of the refinanced mortgage
    • Although the borrower saves on his or her monthly payment for the first ten years of the refinanced mortgage (as compared to financing the college tuition loan separately) and even though the interest rate on the separate tuition loan (7.0%) is greater than the interest rate on the refinanced mortgage (5.0%), the borrower pays $117,600 more in total interest over the life of the refinanced mortgage as compared to not refinancing and obtaining a separate college tuition loan
    • The increase in total interest expense is caused by refinancing the original mortgage ten years into the loan, which effectively increases the term of the original mortgage from 30 to 40 years
    • The longer the mortgage term, the greater the interest expense
    • The borrower refinances the original mortgage into a new 30 year fixed rate mortgage at a lower interest rate of 4.0%
    • By refinancing the borrower saves $1,144 per month for the first ten years of the refinanced mortgage (because of the lower interest rate and because the borrower is not making a monthly payment on a separate college tuition loan) and then saves $564 per month for the following twenty years of the refinanced mortgage
    • Because the borrower was able to lower his or her mortgage interest rate from 7.0% to 4.0%, the borrower pays $25,683 less in total interest over the life of the refinanced mortgage as compared to not refinancing and obtaining a separate college tuition loan
    • The decrease in interest rate offsets the impact of effectively extending the mortgage term from 30 to 40 years by refinancing
  • Use our free mortgage quote feature to review quotes from leading lenders.  Our quote feature is personalized, easy-to-use and requires minimal personal information.  Comparing quotes enables you to find lender and loan that are right for you.

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  • Sources

    Cash Out Refinance: http://myhome.freddiemac.com/refinance/cash-out.html

About the author

Michael Jensen, Mortgage and Finance Guru

Michael is the co-founder of FREEandCLEAR. Michael possesses extensive knowledge about mortgages and finance and has been writing about mortgages for nearly a decade. His work has been featured in leading national and industry publications. More about Michael

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