Should you raid your emergency fund to refinance?

House on top of bundles of bills

Suppose you haven’t refinanced at today’s great interest rates, and you have some cash to burn.

Could some of the money in your emergency fund be better used to help you grab a cheaper home loan? In other words, is a cash-in refinancing right for you?

The answer: not if you have less than six months of expenses saved in the bank.

But if you do have a healthy rainy-day fund, the combination of a lower mortgage rate and a smaller balance could dramatically reduce your monthly payments and save you tens of thousands of dollars in interest costs.

"It may be wise to do a cash-in refi if it lowers your rate significantly and doesn’t deplete your emergency fund," says Jay Dacey, a mortgage broker with Metropolitan Financial Mortgage Company in suburban Minneapolis. "The bigger the rate drop, the more it makes sense."

Indeed, using some of your savings might be the only way you can qualify for a refinancing if you don't have enough equity in your home.

Let's say you paid $200,000 for your home in 2007, put 0% down and have a fixed interest rate of 6% on a 30-year mortgage. Your monthly mortgage payment is about $1,200, and, in five years, you've whittled your principal down to about $185,000.

But with the housing market crash of a few years ago, you don't have much equity in your home, even if the real estate market has improved in your area.

When is a cash-in refi right for you?

If you can't get a mortgage through the Home Affordable Refinance Program or other government options, you'll probably have to bring some cash to the table in order to refinance.

That's because many banks will refinance your home for no more than 80% of the home's current value. Even if you find a bank or mortgage company willing to refinance your loan with 5% or 10% equity, it will require you to buy private mortgage insurance (PMI) to protect the lender in case you default.

PMI could wipe out any savings a lower interest rate might provide.

Cash-in refinancing also could make you eligible for a shorter-term loan. Right now, choosing a 15-year loan over a 30-year loan would lower your interest rate by about three-fourths of a percentage point on average.

Your monthly payment could increase with this option, but in the long run, you’ll pay far less in interest.

Our 15-year vs. 30-year mortgage calculator can help you figure out the potential savings for the deals you find.

Aside from those reasons, for every $10,000 you kick in from your savings, you’ll lower your monthly payment by an additional $45 and save more than $6,100 in interest over the life of the new 30-year loan.

In the example we've been using, let's assume you need to bring $25,000 to the closing table to have 20% equity. You'd be seeking a $160,000 mortgage.

What a 30-year loan costs

Amount financed Monthly payment
$200,000 $900
$190,000 ($10,000 cash-in) $855
$180,000 ($20,000 cash-in) $810
$170,000 ($30,000 cash-in) $765

At today's rates, you'd have a monthly mortgage payment of $746, or more than $400 less than you're paying now. By refinancing into a 30-year loan, you'd be adding five more years of payments, but you would still save about $65,000 in interest payments compared with your original loan.

You'd see even greater savings with a 15-year loan. You'd cut about $100 off your current monthly mortgage payment, shave 10 years off the life of your loan and save $134,200 in interest.

Grabbing a new loan vs. saving

So how do you make the difficult decision of whether to do a cash-in refi or keep your cash in the bank?

"Just as a first-time home buyer shouldn't put every dollar they have saved as a down payment, a person refinancing shouldn’t drain the bank just to get a lower rate," Dacey says.

You’ve probably figured out in your five years of home ownership that you always need to have cash on hand, not just for the usual emergencies like car trouble, medical bills and job loss, but for home repairs, which can crop up suddenly and sometimes cost thousands of dollars.

As a homeowner, it’s justifiable to have a much larger emergency fund than the often-recommended six months of living expenses.

Refinancing isn’t an emergency, so if dipping into savings will deplete your account, don't do it.

Whether you should continue to keep the excess in savings or cash it in when you refinance ultimately comes down to your risk tolerance.

The less you like risk, the more cash you should keep on hand.

The more you’re willing to sacrifice some security to pay less interest on your mortgage, the more you should cash in.

The interest you're earning on your account probably isn't a factor, since savings rates are so low. If you stay in your home for several years, you're bound to recoup your investment, which you can use to add on to your savings.

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