The longer you make payments on your existing mortgage, the more equity you gain. Equity is the home’s value that you’ve paid for and now own. You can also acquire equity when the value of your home increases.
When you apply for a cash-out refinance, it means you want to take out some of that equity in a lump sum of cash. It also requires you to replace your current mortgage with a new one, but for more than you owe on your home. You receive the difference in cash to use as you please — pay off debt, home improvements, pay student loans. Although, as you’ll learn in this guide, some uses of the cash are better than others.Check your cash-out refinance rates. Start here (Dec 6th, 2023)
Pros of a cash-out refinance
You can reap a bounty of benefits if you meet these conditions:
- A lower interest rate. Refinancing your mortgage can lower your interest rate, especially if you purchased or refinanced your home a few years ago when rates were much higher. For example, if you bought your current home in 2018 your interest rate for a 30-year fixed loan could be as high as 5%. Today rates average between 3 to 4 percent. If you only want to lower your interest rate and don’t need the cash, you’ll do better with a regular refinance.
- A higher credit score. If you use the cash to pay off your outstanding debts, you’re on the road to increasing your credit score. That’s because you’ve decreased your credit utilization ratio or the percentage of your credit amount that you’re currently using.
- Debt consolidation and other uses for the cash. When you pay down your credit cards and other bills, you can then consolidate the remainder of the debt into one account with a lower interest rate. Other positive uses for the cash from a mortgage refinance include contributing to your retirement savings, starting or adding to a college fund, and making home renovations.
- A tax deduction. If you put the cash into home improvements, you may be able to write off the mortgage interest. Whatever modifications you make must substantially add to your home’s value in order to do this. These might include adding a stone veneer to the exterior, building a deck and patio, a major kitchen remodel, or updating a bathroom.
Cons of a cash-out refinance
There are a number of downsides to a cash-out refinance though, including:
- Requires an appraisal. Cash-out refinances require an appraisal by a certified, state-licensed home appraiser. This person determines your home’s value by visiting your property, comparing it to similar properties, and then writing a report using the data he’s gathered. An appraisal usually costs from $400-$600. Depending on the state of the real estate market, scheduling and completing an appraisal may take some time.
- Closing costs. You must pay the closing costs when you receive a cash-out refinance loan. Typically, these are between 2-5 percent of the entire new loan amount and include lender origination fees, attorney’s fees, and the appraisal fee, if you haven’t already paid that separately. Due to the high costs of a refinance, these loans are best when you’re taking out a large sum of money. For example, paying $5,000 in closing costs isn’t worth it if you’re only getting $10,000 in cash. You’re better off getting a home equity line, which comes with lower closing costs. But if you’re getting $100,000 cash from the transaction, it may be worth the extra fees.
- Private mortgage insurance. When you borrow more than 80 percent of your home’s equity or value, you’ll have to obtain private mortgage insurance (PMI). This insurance protects the lender in case you don’t make your payments. Currently, PMI costs from .05-1 percent of your loan amount. You usually have two options – a one-time upfront annual premium paid at closing or you can roll the PMI into your monthly loan payments. Generally, it’s not worth adding PMI to your loan just to get cash out of the home. Consider a home equity line or loan, which does not require PMI.
- Foreclosure risk. If, at some time in the future, you’re unable to make your mortgage payments, you risk losing your home due to foreclosure. Your home becomes the collateral for any kind of mortgage you have.
- Different loan terms. Your loan terms may change when you get a cash-out refinance. You’re paying off your original home loan and swapping it for a new one and that means new terms. Following are a few changes that could happen: The new mortgage may take longer to repay our monthly payments may go up or down Your interest rate could change. Be sure to read the Closing Disclosure to note your new loan terms. This is what to look for in the document.
- You don’t get your cash instantly. The processes involved with approving a mortgage loan or a refinance — an appraisal, the underwriting — may take 30-60 days, depending on how busy mortgage lenders are when you apply. On top of that, there is a 3-day “rescission period” toward the end of the loan where, by law, you can cancel the loan if you feel it isn’t the right move. All in all, a cash-out refinance is not a good solution if you need quick cash.
Best and worst uses of a cash-out refinance
Although the cash you receive from a cash-out refinance can buy whatever you please, you might want to consider the consequences of some of these purchases. Let’s start with some of the best ways to use your cash.
- Home improvement projects. According to HomeAdvisor the average cost to remodel a bathroom runs around $10,000, while the national average for a complete kitchen remodel is $25,100. For expensive improvements like these, a cash-out refinance can be the way to go. You’ll also increase the value of your home with certain improvements like those listed and energy-efficient appliances, adding more square footage like a new home office and replacing windows.
- Paying off credit card debt. This can be a good idea, as some credit card interest rates run as high as 18 percent. However, you’ll need to employ some tactics to keep from running up new balances on those credit cards. Stick to a budget that balances your expenses and your income. When you do make a credit card purchase, which you’ll want to do to rebuild your credit score, either have the cash on hand to back up that spending or pay it off right away. And, build up an emergency fund with what you would have been paying in credit card interest. That way you’re less likely to get into trouble with credit cards again.
- Add to your existing investments. This may be wise if those investments are gaining at a higher rate than your refinance rate. It’s best to check with a trusted financial planner before using this option.
- Purchase a rental property. This can be a positive use of the cash as long as you don’t mind all the work you’ll need to do. Investigate the legal and financial ramifications before going down this path.
- Buy a vacation home. If you don’t want to be a landlord, you could use the cash from your cash-out refinance as the down payment on your very own vacation spot.
- Put it to use for an existing business of yours or your new startup. Having emergency cash for a business can come in handy.
How to get a cash-out refinance
Now that you’ve decided a cash-out refinance meets your needs, what steps should you follow?
Check your credit score at one of the free sites like annualcreditreport.com or your credit union. Most lenders require a credit score of 620 or higher for a cash-out refinance. If your score falls below that, you’ll need to work on raising it before applying for a cash-out refinance. You’ll also need to check your debt-to-income ratio, which needs to be less than 40-45 percent. This is the amount of your monthly debts divided by your total monthly income.
You must have also accrued substantial equity in your home to take out a cash-out refinance. Removing 100 percent of your equity isn’t allowed unless you qualify for a VA cash-out refinance (requires military service history) and that lender allows a loan of 100 percent.
It’s a good idea to know how much cash you’ll need ahead of time. If you’re going to use the money for household improvements, first get some estimates from contractors so you’ll have a good idea of what those upgrades will cost. To pay off high-interest debt, like credit cards, tally that total before asking for cash-out refinance.
That way you only take out the amount of equity you really need and can leave some.Check your cash-out refinance rates. Start here (Dec 6th, 2023)
What are the alternatives to a cash-out refinance?
There are many scenarios in which a cash-out refinance is not the best loan option: You want to keep closing costs to a minimum You have less than 30-40% equity in the home You are seeking a relatively small amount of cash, say $5,000 – $20,000.
In these cases, you should at least consider a cash-out refinance alternative.
Home Equity Line of Credit: How is a HELOC different from a cash-out refinance?
A home equity line of credit (HELOC) differs considerably from a cash-out refinance. It’s still secured by your home, but it doesn’t replace your existing loan. It’s an additional, totally separate loan, which is why HELOCs are sometimes known as second mortgages.
You can think of a HELOC like an open-ended loan, somewhat like a credit card. You borrow against the HELOC as the need arises, and when you repay, you still have access to borrow again up to the available limit.
Most HELOCs come with an adjustable interest rate, which means the rate can change month to month. The lender allows interest-only repayments for a certain amount of time and usually the borrower can only access these funds for 10 years, which is called the draw period. When the draw period is over, you pay a regular monthly payment which will fully repay the mortgage balance, typically over an additional 10 years.
Home Equity Loan: How is a home equity Loan different from a cash-out refinance?
A home equity loan, also secured by your home, is for a fixed amount of money that you repay over a fixed amount of time. Like a home equity line, it’s an additional loan that sits on top of your current primary mortgage.
But unlike a home equity line, you don’t have access to borrow funds again and again. So these are better for one-time projects.
The amount you can borrow is usually 85 percent or less of the equity you have in your home. Your income, your credit history, and the market value of your home also factor in to determine how much you can borrow.
This is the main difference between a home equity loan and a cash-out refinance.
Home equity loan: Is a second mortgage on your home. The existing primary mortgage stays intact
Cash-out refinance: Converts your current mortgage into a separate larger one, with up to 30 years to pay it off. In the end, you just have one loan.
Would a cash-out loan, home equity loan, or a personal loan work best for your situation?
How long you’ve owned your home, and your current interest rate should factor into your decision about what type of loan will work the best for you. Consider the following scenarios and decide which one fits your circumstances:
Scenario 1: High Current Rate, Lots of Equity
Homeowner No. 1, a couple, has a high-interest rate (8% or higher) on their current mortgage and they’ve earned a sizable amount of equity (70-85%). This homeowner wants to lower their interest rate and at the same time pull out some cash. The home is old enough that some home improvements won’t wait much longer, plus they’d like to increase the value of their property in case they want to sell and downsize in the future. Homeowner No. 1 is a good candidate for a cash-out refinance.
Scenario 2: New Homeowner, Little Equity
Homeowner No. 2, a family, recently bought the home they’re living in, so they don’t have much equity yet. This family looks forward to sending their son to college in two years but doesn’t quite know how they’ll afford it without burying them all in student loan debt. Other homeowners in this category might need money for household repairs, or to pay their credit card bills. All these homeowners will be best suited to either a personal loan or a personal line of credit.
Scenario 3: Homeowner with Equity and a Low Rate
Homeowner No. 3, a single man, already has a very low mortgage rate and can’t see how he can get a better one. Still, he needs money to replace appliances, which all seem to be breaking at the same time. Refinancing isn’t a good option for him, since he’ll lose his current low rate and would have to accept a higher interest rate. So he’s going to check into adding a home equity loan or a home equity line of credit to his existing first mortgage. See below for more information on how home equity lines/loans work.
Get approved for a cash-out refi
During the approval process, the lender may ask you for additional documents like bank statements, pay stubs, or income tax returns. Having these financial papers readily available will help streamline your approval.
Address any questions you have to your lender. Soon you’ll have the cash you need.Check your cash-out refinance rates. Start here (Dec 6th, 2023)