September 24, 2001
"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 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%.
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 the Refinance
to Raise Cash or Take a Second Mortgage calculator.
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.
Copyright Jack
Guttentag 2002
