For most people, home ownership is one of the biggest investments they will make in their lifetime. Home ownership can build wealth as equity increases in your home through principal reduction on your mortgage(s), home market appreciation, or a combination of both.
Once you have sufficient equity in your home, you may consider utilizing it for common reasons such as home improvements, debt consolidation, higher education, buying a vacation home, and more. The loan process for pulling cash out of your home is referred to as a “cash-out refinance.”
With a “cash-out refi,” as it’s sometimes called, you take out a new mortgage loan for a larger amount than your existing mortgage. You receive the difference in cash. It is only possible to do a cash-out refinance if you have sufficient equity (ownership) in your home that you can tap into.
The Basics of How Cash-Out Refi Works
Here’s a hypothetical scenario to get an idea of how a cash-out refinance could work:
Let’s say you have a home valued at $300,000. You owe $100,000 on your current mortgage, so you have $200,000 equity in the house. Perhaps you need $40,000 to do some home repairs, so you refinance your existing mortgage in the amount of $140,000. In this scenario, the $100,000 of your new mortgage loan would go toward paying off your existing mortgage along with applicable costs (if any) due at closing, with the remaining amount back in cash.
Upon closing on the cash-out refi, you will have a completely new mortgage, and the terms of your previous home loan, including the interest rate, term, and monthly payment may all be different—higher or lower, depending on the new terms you choose.
If you’re in need of cash for home repairs or for any other reason, a cash-out refinance is not your only option. Here, we will examine the cash-out refi process, the pros and cons of a cash-out refi, and other options for getting a lump sum loan.
What is Cash-Out Refinancing Used For?
Technically, you can use a cash-out refinance for just about anything you want. You may be able to take additional cash out of your house for much-needed home improvements and still have the same or lower monthly payment as your current loan. Other common uses for a cash-out refinancing include funding a downpayment for a second home or paying off credit card debt or other high-interest debt.
Ideally, a cash-out refi would result in an interest rate that is lower than what you have on your existing mortgage; however, you should examine your overall financial situation to determine the best outcome for you.
If a lower interest rate is your goal, but you are unable to get it, there are other options you may want to consider.
Cash-Out Refinancing Eligibility
In addition to having equity in your home, lenders consider many factors to determine your eligibility for a cash-out refi. Here are a few examples of what lenders look at:
Credit score: If you have an improved financial situation since you took out your initial mortgage, it’s possible you may have a higher credit score. A higher credit score could ultimately put you in contention for a more favorable interest rate.
Loan-to-value (LTV) ratio: This is a percentage that reflects the difference between the outstanding principal balance of the current mortgage versus the current appraised value of your home. Using the example from above, a person with a home with an appraised value of $300,000 and a $150,000 remaining principal balance on their existing mortgage has a 50% loan-to-value ratio. ($150,000 / $300,000 = 50%.)
Appraisal value: Some refinances will require a property valuation—typically a recent appraisal. However, some lenders may find an alternative to a full appraisal, like an electronic valuation, so it doesn’t hurt to ask your lender about other options.
Seasoning: Seasoning relates to how long you’ve had your mortgage. Once you’ve had your mortgage for six months, many lenders consider the mortgage “seasoned.” But properties that have been listed for sale within the past 12 months preceding loan application are typically not eligible for a cash-out refinance. Why? Because banks don’t typically want to see someone take out a new mortgage and then immediately apply for a cash-out refi.
Pros of Cash-Out Refinancing
Potentially lower rates: If you have good, established credit, it may be possible to refinance for a lower rate than you could get with other types of loans like a home equity line of credit.
Improved credit score: If you use the money to pay off higher-interest debt like credit cards, your credit score may get a boost.
Mortgage interest deductions: Mortgage interest for cash-out refinance loans may be tax deductible. Consult with your tax professional for more details as they apply to your unique situation.
Cons of Cash-Out Refinancing
A reduction in equity: Increasing the secured lien on your home reduces the amount of available equity. Downward market fluctuations can further reduce the amount of available equity in your home. These are important considerations when determining the purpose and amount of a cash-out refi.
Length of loan: If your cash-out refi is for a term longer than what you have remaining on your current loan, you could be extending the length of time you’re paying a mortgage back, which means paying more in interest over the life of your mortgage loan.
Risk of foreclosure: You’re putting your home at risk any time you use it as collateral for a loan. In the event you can’t make your monthly payment, the bank could foreclose on your home.
Are There Other Options?
Home Equity Line of Credit (HELOC): A HELOC is a revolving line of credit that uses your house as collateral. Borrowers typically don’t take a lump sum HELOC unless they know they can pay it back. Instead, with a HELOC, the borrower is given a credit limit, and because the credit is revolving, they can use it, pay it back, and then tap into it again. HELOCs typically offer variable rates that could change over the course of the loan.
Home Equity Loan: A home equity loan also uses your house as collateral, but offers a lump sum payment. Home equity loans often have a fixed interest rate, and are typically chosen when a borrower knows how much cash they will need up-front. A home equity loan is separate from your mortgage, and often offers different terms.
Personal Loan: Personal loans are typically unsecured, which means that they do not require existing assets (like your home) as collateral. This usually means higher interest rates than loans that are secured by collateral.
Making the Right Choice for Your Finances
When determining the right option for you, consider your decision from a few angles. One of the factors in determining the right loan for you is the amount of time it will take to pay back the additional funds needed.
For instance, if you are planning on receiving a lump some of money from a stock sale or inheritance, it may make sense to take out a shorter-term loan, which may save you money on interest. No matter what you choose, it’s wise to consider the all-in costs of each possible option.
And of course, do your research. There are many important factors to consider when taking cash out of your home. Determine what you need the money for, and for how long. Compare the costs to the money potentially saved by refinancing to a lower interest rate. And shop around to find the right option for you!
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This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice about bankruptcy.
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