Borrowers who withdraw cash when they refinance are viewed as riskier than those who don't, because the cash withdrawal indicates possible financial distress – and that perception can raise a borrower's costs.

The rate on cash-out deals is higher than on no-cash deals that are otherwise identical. The price difference is particularly large when the borrower's credit score is low, an illustration of "risk layering."

Note that refinancing borrowers can increase their loan balance by enough to cover their settlement costs without the loan being classified as "cash-out." The borrower must literally walk away with cash for the transaction to be "cash-out."

Whether or not cash is withdrawn is entirely within the borrower's discretion. But many use the discretion unwisely because they underestimate the cost of the money they take out of the refinance. They view the cost as the rate on the new mortgage, ignoring the higher cost on the existing loan balance.

For example, consider the borrower with a credit score of 620 who could refinance a $240,000 balance at 4.14 percent but instead refinances $254,000 at 4.88 percent in order to get $14,000 in cash. The interest cost of the $14,000 is not 4.88 percent because this ignores the higher rate the borrower must pay on the $240,000 balance. If this additional cost is added in, as it should be, the borrower is paying 15.24 percent rather than 4.88 percent. At that rate, there could be much better options for raising cash.

Note that a cash-out deal raises the ratio of loan amount to property value, or LTV. If the borrower must pay a higher mortgage insurance premium at the new LTV, the cost of the cash taken out would be raised even more.

The mortgage interest rate is not usually affected by the LTV, but if the ratio is above 80 percent, the borrower must pay for mortgage insurance. The insurance premium rises with the LTV and is also subject to the same risk factors as the mortgage rate. Borrowers with low credit scores, for example, will pay higher mortgage insurance premiums as shown below.

Borrowers should be aware of the LTV categories shown in the graphic, which I call pricing notch points or PNPs. If they intend to finance their closing costs, and especially if they intend to take cash out, they should make sure that this will not breach a PNP and raise their cost. If they find that their loan-to-value ratio is just above a PNP – say, 85.1 percent – they should beg or borrow the amount needed to reduce the loan amount to the lower price bracket. It would be a very high-yield investment.

Borrowers with LTVs above 80 should make sure that they are not paying more than necessary for mortgage insurance. You can check the premium quoted to you by your lender on my site, http://www.mtgprofessor.com/. While there, you can also check whether or not you might do better with a financed single-premium plan, as opposed to a monthly premium plan. Most lenders only quote monthly premiums, even though in some cases the single premium plan would be less costly to the borrower.

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ABOUT THE WRITER:

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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