There may come a time when you need to access a large amount of cash to pay off credit card debt or fund home improvements. And when that happens, you can consider using one of the greatest assets at your disposal—your home’s equity.
A cash-out refinance is a mortgage refinancing option that allows you to renegotiate the terms of your mortgage and turn your home equity into cash. This article will explain what a cash-out refinance is, the pros and cons, and how to determine whether it’s right for you.
What is a cash-out refinance?
A cash-out refinance is a type of mortgage refinance that allows the homeowner to take out a new loan for more than what they owe on their current mortgage. This new loan is used to pay off the old mortgage and the remaining funds are given to the homeowner in cash.
This option can be a good choice for homeowners who want to access the equity they’ve built up in their home and use it for other expenses, such as home renovations, paying off high-interest debt, or investing in other opportunities.
How does a cash-out refinance work?
The lender will thoroughly evaluate the terms of your previous loan, examining both your credit history and the remaining balance. They will then formulate an offer based on a comprehensive underwriting analysis.
With cash-out refinancing, you take out a new loan that exceeds your current loan balance. This new loan pays off your previous loan, leaving you with a new mortgage and monthly payment, along with a “cash-out” amount that represents the difference between the new loan amount and what was owed.
Cash-out refinancing is different from simply refinancing your home where you don’t see any cash in hand. With a traditional mortgage refinance, you take out a new loan for the same amount but at a lower interest rate and monthly payment.
Similar to a home equity loan, the goal of cash-out refinancing is to access the equity in your home. Cash-out refinances are usually less expensive than home equity loans.
Pros and Cons of a Cash-Out Refinance
There are advantages and disadvantages to any financial decision, and this is certainly true for a cash-out refi. Understanding some of the pros and cons can help you decide whether this is the right move for you.
Pros
- Consolidate debt: The average interest rate on credit cards is 17.25%. But if you’re carrying a balance from month to month, this can add up to a lot of money in interest. Using a cash-out refinance to pay down credit cards can save you thousands of dollars.
- Fund home improvement projects: Home improvement projects are typically a good investment because they increase the value of your home. However, not all projects will add the same amount of value, so make sure you do your homework first.
- Boost your credit score: If you use the money to pay off debt, this will lower your credit utilization. This impacts your credit score by up to 30%, so reducing this can improve your score.
- Improve your home loan terms: When you refinance your home, you’re replacing your existing mortgage with a new one. This could mean shorter payment terms, and you may be able to qualify for a lower interest rate.
- Possible tax deduction: If you use the money to improve your home, you may be able to take advantage of the mortgage interest deduction. You should consult a tax professional to find out if you qualify for the deduction.
Cons
- Private mortgage insurance (PMI): If the value of your home falls below 80%, you’ll have to pay PMI. PMI costs between 0.5% to 1.0% of the total loan amount. So, you need to be sure the benefits you stand to gain outweigh these costs.
- You’ll have new mortgage terms: In some situations, taking out a new mortgage loan with new terms could be an advantage to you. But if you already have a very low interest rate, this could work against you. Make sure you understand the terms and conditions before agreeing to anything.
- Closing costs: When you refinance your home, you have to pay closing costs, which are the fees paid to finalize a real estate transaction. They are usually between 2% and 5% of the loan amount, so this will be thousands of dollars you’ll have to pay out of pocket.
- Won’t fix bad financial habits: Using a cash-out refinance to pay down debt can be a smart decision. But it won’t help you if you rack that debt back up again. Make sure you work on improving your financial habits so you don’t stay stuck in a cycle of debt.
- You put your home at risk: With a cash-out refinance, your home is used as collateral to guarantee the mortgage loan. So if you’re unable to make your monthly mortgage payments, you are in danger of losing your home.
Understanding the Cost of Cash-Out Refinancing
When you’re considering a cash-out refinance, it’s crucial to understand the associated costs. This step can ensure you make an informed financial decision and know exactly what to expect.
Closing Costs and Their Impact
Much like your original mortgage, a cash-out refinance comes with closing costs. These fees are paid to your lender and other third parties involved in the transaction. They typically range from 2% to 6% of your new loan’s balance. For example, if you’re refinancing a $200,000 loan, your closing costs might be between $4,000 and $12,000.
Closing costs can significantly impact the overall cost of your loan. If you’re taking cash out for a short-term need and plan to pay off your loan quickly, high closing costs could make your loan more expensive than other short-term lending options.
However, if you’re spreading the costs over a longer-term loan, the impact of these costs on your monthly payments might be less noticeable. It’s essential to factor these costs into your decision to ensure the refinance is financially beneficial.
Changes to Mortgage Payments and Interest Rates
Cash-out refinancing can potentially change your mortgage payments and interest rates. If you’re increasing your loan amount to cash out your home’s equity, your mortgage payment might go up, even if you secure a lower interest rate. This is especially true if you choose a loan term that’s shorter than the remaining term on your current mortgage.
Conversely, if you secure a lower interest rate or choose a longer-term loan, your monthly payments might go down. However, remember that a longer-term loan could lead to paying more interest over the life of the loan, even if your monthly payments are lower.
Factors to Consider Before Opting for Cash-Out Refinancing
Choosing to pursue a cash-out refinance is a substantial financial decision that requires careful thought and planning. It’s important to evaluate several factors before making this decision.
Assess Your Financial Health and Credit Score
One of the first factors you should consider is your personal financial health, and a key component of that is your credit score. Your credit score impacts the interest rates you can qualify for – the higher your score, the lower the interest rates you’re likely to receive.
It’s also important to evaluate your overall financial health. This means taking into account your income stability, savings, debt-to-income ratio, and emergency funds. If your financial health is strong, you might be in a better position to take on a cash-out refinance.
Current Market Interest Rates
Interest rates are a pivotal factor to consider. The current market conditions might dictate whether it’s a good time to refinance. If the rates are low, you could potentially secure a deal that reduces your monthly payment or allows you to pay off your mortgage faster. Keep in mind, though, that rates can fluctuate, and predicting future changes can be difficult.
Evaluate Your Long-Term Financial Goals
Your long-term financial goals should play a significant role in your decision-making process. Are you planning for retirement? Saving for your child’s education? Considering a major purchase or investment? The answers to these questions can guide your decision. If the funds from a cash-out refinance can help you achieve these goals or if the lowered monthly payment can free up money for other priorities, it might be a good choice.
Availability and Terms of Other Financing Options
Finally, consider the other financing options available to you. Compare the terms and conditions of personal loans, home equity loans, or home equity lines of credit to the terms of a cash-out refinance.
For instance, if you need funds for a short-term goal, a personal loan or a HELOC may be a better choice due to lower closing costs, despite potentially higher interest rates. But if you need to consolidate high-interest debt and want to take advantage of a lower, fixed interest rate, a cash-out refinance might be more suitable.
How can you use a cash-out refinance?
The money you receive from a cash-out refinance can be used for pretty much any purpose. You can use it to pay off high-interest credit card debt or for home renovations.
However, just because you can use this money for any expense doesn’t mean you should. Paying down high-interest debt is a good move because it’ll reduce the amount you pay in interest. And home improvements can help you increase your home’s value.
But it’s not a good idea to use a cash-out refinance to fund things like vacations or brand-new cars. The return on your investment will be minimal, and you’ll be putting your home at risk for very little reward.
How to Get a Cash-Out Refinance
Getting a cash-out refinance involves several key steps. By understanding these steps and preparing accordingly, you can enhance your chances of a smooth and successful refinancing process.
Detailed Process and Requirements
The cash-out refinance process starts with an evaluation of your financial situation and the current state of your mortgage. This includes your credit score, income, debt-to-income ratio, and the amount of equity in your home.
Once you decide that a cash-out refinance is the right choice, the next step is to apply with a lender. The lender will evaluate your application, including a thorough review of your financial situation, and will typically require an appraisal of your home to determine its current market value. If approved, the lender will provide the terms of the new loan, including the interest rate and the amount you can cash out.
Selecting a Lender
Choosing a lender is a crucial step in the refinancing process. It’s advisable to shop around, comparing the loan terms and rates of various lenders to find the best deal. It’s also essential to consider the lender’s reputation, customer service, and the speed at which they can process your refinance. Online reviews and ratings can be a useful tool in assessing these factors.
Preparing for the Application Process
Preparation is key to a successful application process. Ensure your credit report is accurate and your score is in good shape. Gather all necessary documents, such as proof of income, bank statements, tax returns, and information about your current mortgage. Remember that the lender will also need to assess your home’s value, so having a realistic idea of this beforehand can be helpful.
Understanding the Timeline and What to Expect
Refinancing isn’t an overnight process – it can take anywhere from 30 to 45 days, or sometimes even longer. This timeline can be influenced by many factors, including the lender’s processing speed and the time taken for the home appraisal.
During this time, the lender will be reviewing your application, checking your credit, verifying your financial information, and arranging for the appraisal. Once all the checks are completed and the lender approves the loan, you’ll move on to closing. Here, you’ll sign the new loan documents, pay the closing costs, and receive the cash from your refinance.
Knowing what to expect at each step can help you prepare and ensure the process goes as smoothly as possible.
Alternatives to a Cash-Out Refinance
Cash-out refinancing won’t be the right choice for everyone. If you need to access a large amount of cash but aren’t sure about a cash-out refinance, there are alternatives you can consider.
- HELOC: One of the most popular alternatives to a cash-out refinance is taking out a home equity line of credit (HELOC). A HELOC is somewhat like a personal loan and a credit card all rolled into one. It’s a revolving line of credit and is less expensive and less time-consuming than a cash-out refinance. Plus, you’ll only pay interest on the money you actually borrow.
- Personal loan: If you want access to a large, lump sum of money, personal loans could be a suitable alternative. These loans are faster to process than a cash-out refinance, and you’ll pay off the money in a much shorter time period.
- Look for other ways to find the money: And finally, you may want to consider if there are other ways you can find the money you need. Could you borrow the money from friends or family or take on a side job? This isn’t the most exciting alternative, but if you can make it work, it’ll save you from taking on more debt.
Summary
In the right circumstances, cash-out refinancing can be a good move. It can help you re-invest into your home, pay off debt, and improve your financial situation.
However, cash-out refinancing is not a quick fix. If you don’t change the behaviors that created the problem, you risk digging yourself into an even deeper financial home. Plus, you’re putting your home at risk in the process.
If you choose to go forward with a cash-out refinance, be sure to put your money to good use. Use this experience to put you and your family in a better position financially.
Frequently Asked Questions
What kind of credit score is needed for a cash-out refinance?
Most lenders require a credit score of at least 620 to qualify for a cash-out refinance, though the exact requirements can vary. The higher your score, the better terms you’ll likely receive.
How much cash can you get from a cash-out refinance?
The amount of cash you can get from a cash-out refinance depends on the amount of equity you have in your home and the lender’s specific requirements. Typically, lenders allow you to borrow up to 80% of your home’s value, including your current mortgage and the cash-out amount.
For example, if your home is worth $300,000 and your current mortgage balance is $150,000, you could potentially borrow up to $90,000 in a cash-out refinance. However, the specific amount can vary based on your creditworthiness, debt-to-income ratio, and other factors.
How much equity do I need in my home to qualify for a cash-out refinance?
Typically, lenders require you to have at least 20% equity in your home to qualify for a cash-out refinance. This ensures that you have a buffer should home prices decline, and it reduces the risk for the lender.
Can I still qualify for a cash-out refinance if I have a high debt-to-income ratio?
A high debt-to-income (DTI) ratio can make it more challenging to qualify for a cash-out refinance. Most lenders prefer a DTI ratio of 43% or less, but some may have stricter requirements. Even if you qualify with a high DTI, you may receive less favorable loan terms.
How long does a cash-out refinance take?
A cash-out refinance can take anywhere from 30 to 45 days, or sometimes even longer. The exact timeframe depends on a variety of factors, including the lender’s processing speed and the time taken for the home appraisal.
Can I get a cash-out refinance on an investment property?
Yes, it is possible to get a cash-out refinance on an investment property. However, the requirements for this type of refinancing are often stricter, and you may need to have a larger amount of equity in the property.
What can I do if I’m denied for a cash-out refinance?
If you’re denied for a cash-out refinance, it’s important to understand why. The lender is required to provide you with an explanation. You may need to improve your credit score, lower your debt-to-income ratio, or increase your home’s equity before you can qualify.
