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.
September 24, 2001
