A cash-out refinance is one way for homeowners to access a lump-sum of cash. The process involves borrowing a new mortgage for a larger amount than the existing mortgage. The borrower receives the difference in cash. It is only possible to do a cash-out refinance if the borrower has sufficient equity (ownership) in their home. Generally, lenders limit cash-out refinances to 80% of the equity a borrower has built in their home.
The Basics of How Cash-Out Refi Works
Here’s a hypothetical scenario to illustrate 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 and have $200,000 in equity. In this case, you want to borrow $40,000, so you apply for a cash-out refinance for $140,000.
In this scenario, $100,000 of the refinanced mortgage would go toward paying off your existing mortgage along with applicable costs (if any) due at closing, with the remaining $40,000 received in cash.
Upon closing on the cash-out refi, you will have a completely new mortgage and the terms, including the interest rate, term, and monthly payment may all be different than the previous mortgage.
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, a cash-out refinance can be used for just about anything. Some uses for a cash-out refinancing include home renovations, 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 a lower interest rate than the existing mortgage; however, it’s important to examine your personal 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 that may be worth considering.
Cash-Out Refinancing Eligibility
In addition to having equity in the home, lenders consider a variety of factors to determine eligibility for a cash-out refi. Here are a few examples of what lenders may look at:
Credit score: A higher credit score could help borrowers secure a more competitive interest rate on their cash-out refi.
Loan-to-value (LTV) ratio: This is a percentage reflecting 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 a virtual valuation, so confirm requirements with the lender.
Seasoning: Seasoning relates to the age of a mortgage. If a mortgage is at least 12 months old, lenders generally consider the mortgage “seasoned.” If a mortgage is not considered fully seasoned, it may not be possible to apply for a cash-out refi.
Pros of Cash-Out Refinancing
Potentially lower rates: Borrowers with a strong, established credit history may be able to refinance to a lower interest rate than they might secure with other types of loans like a home equity line of credit.
Improved credit score: If the money is used to pay off higher-interest debt like credit cards, this could potentially offer a credit score boost.
Mortgage interest deductions: Mortgage interest for cash-out refinance loans may be tax deductible, depending on what the money is used for. Consult with a 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 the term on the cash-out refi is longer than the remaining term on the current loan, this could extend the overall length of repayment, which could result in increased interest over the life of the loan.
Risk of foreclosure: Anytime someone uses their home as collateral, it’s at an increased risk. In the event there are issues with making payments, the bank could foreclose on the home.
Closing Costs: Borrowers will often have to pay closing costs, anywhere from 3% to 5% of the total loan amount (including the old loan and the amount that is cashed out) , which can add up quickly.
Are There Other Options?
A cash-out refinance isn’t the only option if a homeowner is in need of cash. Here are a few to consider.
Home Equity Line of Credit (HELOC)
A Home Equity Line of Credit (HELOC) is a revolving line of credit that uses the borrower’s 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 the borrower’s 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 the mortgage and often offers different terms.
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. No matter what you choose, it’s wise to consider the all-in costs of each possible option.
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.
Cash-Out Refinancing FAQs
Here are some of the most frequently asked questions when it comes to cash-out refinancing.
Are There Limitations on What the Cash Can Be Used For?
With a cash-out refinance, the money can be used for pretty much any purpose. While the money from a cash-out refinance can be used for anything, remember that borrowing a cash-out refinance loan means removing equity and using your home as collateral. So, while you can use the money for anything, some uses are wiser than others.
How Much Can you Cash Out?
Generally, lenders will limit borrowers to 80% of the equity they have in their home. Keep in mind that this may vary based on a lender’s policies. VA loans are an exception to this, they allow borrowers to take out 100% of the equity in their home.
Does a Borrower’s Credit Score Affect How Much They Can Cash Out
A borrower’s credit score may influence how much they are able to borrow. In general, to borrow a cash-out refinance, lenders will expect a minimum credit score in between 600 and 640. Some lenders may offer cash-out refi loans to borrowers with lower credit scores as well. Each lender will have their own requirements around minimum credit scores, so compare options.
Cash-out refinancing is an option that allows homeowners to tap into the equity in their home. The general process involves borrowing a new mortgage where borrowers can use their existing equity to secure a lump-sum payment.
The money can be used for nearly any expense, from paying off high interest debt to financing a renovation.
Borrowing a cash-out refinance does come with risk, importantly that the borrower is removing equity from their home and the house is used as collateral.
Other alternatives to consider depending on individual financial circumstances include a HELOC, personal loan, or home equity loan.
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