The interest rates charged on a mortgage are directly related to the loan’s risk. The riskier the loan (aka the borrower), the higher the rate a lender will provide. So it probably goes without saying that a cash out refinance often has higher rates. This isn’t always the case, though; it depends on the lender and the factors that you bring to the table.
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The Factors That Contribute to Higher Interest Rates
It’s probably not a fair blanket statement to say that all cash out refinance loans have higher interest rates. It really comes down to your qualifying factors. Some factors count more than others. Here we will cover the most influential factors.
Loan-to-Value Ratio
How much you borrow compare to the value of the home is a big factor. The magic threshold is usually 80%. If you borrow more than 80%, which most lenders don’t allow in a cash-out refinance, you will likely pay a much higher interest rate. This is because your risk level increases. Typically, borrowers that need to borrow more than 80% of the home’s value, have a higher risk of default.
Credit Score
Your credit score gives the lender an overall idea of your ability to handle your finances. A high credit score usually means you are financially responsible. A low credit score can signify that you cannot handle your finances. Of course, there is always the in between as well.
Credit scores can range from 300 – 850. It’s very rare to find someone with an 850 score. Typically, anyone with a score above 750 has ‘excellent credit.’ These borrowers would get the best interest rates on their cash out refinance if everything else on their application is favorable, including the LTV.
You are still in the ‘good range,’ if you have a score between 700 and 749. If you dip below 700, you enter the fair and poor categories. These scores often require lenders to charge you more for the cash out refinance, if they approve your loan at all.
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Debt Ratio
The final factor is your debt ratio. Since you borrow more money when you take out a cash out refinance, the lender is going to pay close attention to your debt ratio. The loan program you use will determine the maximum ratios allowed. In general, though you can expect:
- FHA 28% front-end and 36% back-end
- VA 43% total debt ratio (they don’t monitor the front-end ratio)
- USDA 29% front-end and 41% back-end
- Conventional – 28% front-end and 36% back-end
Every lender will differ when it comes to the debt ratios, though. Some will require lower ratios and others will grant exceptions. Overall, the lower your debt ratio, the better the interest rate a lender can offer you, though.
The Reason for the Cash Out Refinance
Another factor that may play a role in the interest rates you can obtain is the reason you need the cash out. Are you investing it right back into the home? In other words, are you making improvements or adding onto the home? If so, a lender may be more willing to provide the funds. When you invest right back into the home, you likely increase the home’s value. This increases the value of the collateral the bank has for the loan, putting them in a better position.
Now, if you are using the cash to do something other than invest back into the home, a lender may not be as willing to provide the loan. common reasons borrowers take cash out of the equity of their home include:
- Debt consolidation
- Pay for a wedding
- Pay for college
- Pay for a vacation
These are obviously just a few examples, but you can see that they have nothing to do with the home. With the exception of the debt consolidation, the other factors may put a lender at higher risk. The debt consolidation is the exception to the rule as it could put you in a better position. If you consolidate high interest debt into your home loan, you only have one payment to make and it will likely be at a lower interest rate than what you are used to paying. This could lower your debt ratio and make it easier to afford the mortgage.
So yes, sometimes interest rates can be higher for a cash out refinance. In fact, they oftentimes are higher, but you have to shop around. Different lenders have different requirements. Some may provide you with a similar rate to what you are used to if your qualifying factors prove to the lender that you are not a high risk.
