The APR on a Cash-Out Refinance
September 24, 2001, Revised November 30, 2006, January 3, 2008
The APR should not be used in comparing the cost of a cash-out refinance with the cost of raising the same amount of cash with a second mortgage. The reason is that the APR does not factor in the loss of the existing first mortgage, which often carries a lower rate than the new cash-out refinance.
"I need $20,000 and am comparing a cash-out refinancing with a second mortgage loan. The cash-out refinance would be for $185,000 at 8%, with lender fees of $1850 and other settlement costs of $3150. My current mortgage is at 7.5%, has a balance of $160,000 and has 28 years to run. The second mortgage is for $21,000 with lender fees of $630. The APR is 8.11% on the cash-out refinance and 11.56% on the second, yet my intuition tells me that the second is better. Do I go with the APR or with my intuition?"
Go with your intuition, the APR won't give you the right answer on a cash-out refinance.
The annual percentage rate (APR) is a measure of interest cost that takes account of both the interest rate and upfront credit fees. However, the APR on a cash-out refi is not comparable to the APR on a second mortgage. In the first case you are giving up a loan with a lower rate and in the second case you aren’t. In effect, one APR is apples and the other is oranges.
Imagine, for example, that your current loan had a zero interest rate. (This isn’t as ridiculous as it sounds, as you will see shortly). You would obviously lose a lot more from refinancing a zero rate loan than you would refinancing a 7.5% loan, yet the APR on the new loan would remain at 8.11%.
To make it comparable to the APR on a second mortgage, the APR on the cash-out refinance must be converted into a “net-cash APR”.
The standard APR compares the payments on a new mortgage to the loan amount net of upfront credit charges. On a cash-out refi, the old loan is ignored. A net-cash APR, in contrast, compares the difference in payments between the old and new loan to the amount of cash received by the borrower. It thus takes account of the difference in rate between the old mortgage and the new one. In your case I calculated a net-cash APR of 13.16%, significantly higher than the 11.56% on the second. That confirms your intuition.
I have to wonder how many people without reliable intuitions have been led astray by comparing the APRs on cash-out refis with those of second mortgages?
Freddie Mac’s quarterly survey of refinanced loans shows that cash-out transactions usually account for more than half of all refinances. The great majority of cash-out refis have rates above the rates on the old mortgages. Where that is the case, the APR on the cash-out refi is deceptively low.
Recently I have been reading case histories of predatory loans. A sizeable number are cash-out refis. The worst are the ones refinancing zero interest loans granted to beneficiaries of the Habitat for Humanity program. It has been estimated that about ten percent of all Habitat borrowers between 1987 and 1993 subsequently refinanced their zero interest loans into loans carrying rates of 10-16%. See The Cash-Out Refinance Scam.
I doubt that the deceptively low APRs on cash-out refis has played any significant role in helping predators dupe their victims. Yet requiring lenders to report a net-cash APR to cash-out refi borrowers could make it more difficult for predators. If the interest rate on the old loan in the example above was 0% instead of 7.5%, the net-cash APR would be 53%! Numbers like this might shake up borrower-victims enough to think a second time about what they are doing.
Meanwhile, the best way to avoid going astray is to use my calculator 3d, Refinance to Raise Cash or Take a Second Mortgage. The calculator compares all the costs over a future period of the existing loan plus a second with the costs of the new cash-out refi. It also shows the “break even” rate on the second, which is the highest rate you can pay on the second and come out ahead of the cash-out refi.
The APR should not be used in comparing the cost of a cash-out refinance with the cost of raising the same amount of cash with a second mortgage. The reason is that the APR does not factor in the loss of the existing first mortgage, which often carries a lower rate than the new cash-out refinance.
"I need $20,000 and am comparing a cash-out refinancing with a second mortgage loan. The cash-out refinance would be for $185,000 at 8%, with lender fees of $1850 and other settlement costs of $3150. My current mortgage is at 7.5%, has a balance of $160,000 and has 28 years to run. The second mortgage is for $21,000 with lender fees of $630. The APR is 8.11% on the cash-out refinance and 11.56% on the second, yet my intuition tells me that the second is better. Do I go with the APR or with my intuition?"
Go with your intuition, the APR won't give you the right answer on a cash-out refinance.
Why the APR Misleads on a Cash-Out Refinance
The annual percentage rate (APR) is a measure of interest cost that takes account of both the interest rate and upfront credit fees. However, the APR on a cash-out refi is not comparable to the APR on a second mortgage. In the first case you are giving up a loan with a lower rate and in the second case you aren’t. In effect, one APR is apples and the other is oranges.
Imagine, for example, that your current loan had a zero interest rate. (This isn’t as ridiculous as it sounds, as you will see shortly). You would obviously lose a lot more from refinancing a zero rate loan than you would refinancing a 7.5% loan, yet the APR on the new loan would remain at 8.11%.
The APR on a Cash-Out Refinance Should Be Calculated on Net Cash
To make it comparable to the APR on a second mortgage, the APR on the cash-out refinance must be converted into a “net-cash APR”.
The standard APR compares the payments on a new mortgage to the loan amount net of upfront credit charges. On a cash-out refi, the old loan is ignored. A net-cash APR, in contrast, compares the difference in payments between the old and new loan to the amount of cash received by the borrower. It thus takes account of the difference in rate between the old mortgage and the new one. In your case I calculated a net-cash APR of 13.16%, significantly higher than the 11.56% on the second. That confirms your intuition.
I have to wonder how many people without reliable intuitions have been led astray by comparing the APRs on cash-out refis with those of second mortgages?
Freddie Mac’s quarterly survey of refinanced loans shows that cash-out transactions usually account for more than half of all refinances. The great majority of cash-out refis have rates above the rates on the old mortgages. Where that is the case, the APR on the cash-out refi is deceptively low.
Cash-Out Refinancing May Be Predatory
Recently I have been reading case histories of predatory loans. A sizeable number are cash-out refis. The worst are the ones refinancing zero interest loans granted to beneficiaries of the Habitat for Humanity program. It has been estimated that about ten percent of all Habitat borrowers between 1987 and 1993 subsequently refinanced their zero interest loans into loans carrying rates of 10-16%. See The Cash-Out Refinance Scam.
I doubt that the deceptively low APRs on cash-out refis has played any significant role in helping predators dupe their victims. Yet requiring lenders to report a net-cash APR to cash-out refi borrowers could make it more difficult for predators. If the interest rate on the old loan in the example above was 0% instead of 7.5%, the net-cash APR would be 53%! Numbers like this might shake up borrower-victims enough to think a second time about what they are doing.
Use a Calculator
Meanwhile, the best way to avoid going astray is to use my calculator 3d, Refinance to Raise Cash or Take a Second Mortgage. The calculator compares all the costs over a future period of the existing loan plus a second with the costs of the new cash-out refi. It also shows the “break even” rate on the second, which is the highest rate you can pay on the second and come out ahead of the cash-out refi.