Whether you’re looking to remodel your kitchen, pay off credit card bills or cover the cost of college tuition, you’re going to either borrow money or get access to a lump sum of cash. One way to come up with the funds is a cash-out refinance.
With a cash-out refinance, you replace your current mortgage with a new, larger mortgage. The difference between the existing and new mortgage amounts, minus closing costs, goes to you in cash. That may sound appealing, but it’s important to understand all the details first.
What is a cash-out refinancing?
Cash-out refinancing is a loan option for homeowners who want to cash in on the equity they’ve built up on their property. Unlike traditional refinancing, where your new loan replaces your mortgage with a loan of the same amount, a cash-out refi replaces your current mortgage with a larger loan so you can receive the difference in cash.
Most lenders will allow homeowners to borrow up to about 80% of their home’s equity. You can use the lump sum any way you choose, including for home improvements and even debt consolidation.
What does a cash-out refi look like?
If your home is valued at $300,000 and you still owe $100,000 on your mortgage, your equity is the difference: $200,000. If you go with a cash-out refinance, lenders typically require you to maintain 20% of your home’s equity, or $60,000 in this case, so you’d be able to cash out up to $140,000 to use toward that new kitchen.
Requirements for a cash-out refinance
Being a homeowner doesn’t automatically put you in the running for a cash-out refinance. Remember when you submitted information about your finances for your current mortgage? A cash-out refinance is going to feel similar. A lender will take a deep dive into your cash flow and your property’s condition to determine whether they feel comfortable loaning you the money.
- Check with each lender’s cash-out refinance requirements, as they’ll differ by institution. For example, some lenders will allow you to borrow only up to 80% of your home’s equity, while others will let you borrow up to 90%.
- Make sure you have at least 20% equity in your home, the typical percentage lenders require before they consider you for cash-out refinancing.
- Timing matters with cash-out refinancing. For example, Fannie Mae recently announced that homeowners needed to be in their current home for at least 12 months prior to being eligible for a cash-out refinance.
- While most lenders will accept credit scores as low as 620, higher scores translate to lower rates. It’s wise to work to boost your credit score into 700-and-above territory. Lenders will consider your credit history, score and debt-to-income ratio. They’ll also look at your employment and how long you’ve lived in your house.
Benefits to cash-out refinancing
While cash-out refinancing isn’t for everyone, here are some of the potential advantages.
It can help you consolidate and pay off debt: You can use the difference you’re paid from your new home loan to pay off your debt or transfer your debt into an account with a low interest rate. By paying off your debt, you could also improve your credit score.
It helps you make home improvements: Use the cash to finally renovate your kitchen, build an addition or perhaps redo your deck. By investing in your house, you’re increasing the value of your home.
It could get you a tax break: Cash-out refinancing could qualify you for a mortgage interest deduction, a tax break that allows you to reduce the amount you pay in taxes based on how much mortgage interest you’ve paid on your home during that year.
Disadvantages to cash-out refinancing
There are downsides. Here are a few other aspects to consider before committing to a new and larger loan.
It ups your risk of foreclosure: Mortgage loans are secured, meaning they are tied to a piece of collateral, i.e., your home. If you stop making payments on your loan, you could lose your home. That’s why using money you receive from a cash-out mortgage to pay off an unsecured loan, such as a credit card, is considered risky.
It’ll change your loan terms: Because you’re taking on a new loan, you’ll most likely have to agree to new terms for your mortgage. You’ll want to check the new interest rates, fees and term length before agreeing to the loan. In the current market, cash-out refinancing can be a very costly move: Data from Freddie Mac shows that borrowers who refinanced in the first half of 2023 did so with average rates of 6.4% – more than 2 points higher than the average rates for their old loans. That increased monthly payments by an average of $591.
You’ll pay closing costs: Just like when you bought your home, you’ll need to pay closing costs when you refinance it. This is typically 2% to 5% of your total mortgage.
Alternatives to cash-out refinancing
HELOC
A HELOC, or a home equity line of credit, offers homeowners separate loans with revolving credit instead of one large loan. You’ll still have to pay closing costs for a HELOC, however, and your home will still be used as collateral.
Personal loan
Going with apersonal loanis another route to access money for your home improvement projects, with the added bonus of not having to use your house as collateral. But because it’s an unsecured loan, it’ll have much higher interest rates than you’ll find with cash-out refinancing.
Reverse mortgage
If you’re 62 or older and want to make home improvements, you could apply fora reverse mortgage. A reverse mortgage allows you to cash in on your home’s equity and relieves you of monthly mortgage payments. But it uses up your equity, which means fewer assets for you and your heirs. The amount borrowed will have to be paid back when the homeowner either moves out of the home, sells the property or dies.
Home equity loan
Like cash-out refinancing, home equity loans provide you with a lump sum of cash. Home equity loans won’t alter your loan terms, unlike a cash-out refinance, and the interest rate is fixed. But since it’s a second mortgage, with a separate payment, that interest rate tends to be much higher than a first mortgage.
Bottom line
A cash-out refinance can be a useful financial move for a homeowner who has a sizable chunk of equity and needs money to complete a major project or pay off another large expense. In some cases, a cash-out refinance comes with potential tax benefits, too. However, don’t let the advantages distract you from the downsides. You’ll be taking on more debt – and you’ll be putting your house on the line in the process.
FAQs
You’ll be opening a new loan and increasing the overall amount of money you owe. Both of these are key factors in determining your credit score.
Bankrate’s data shows that the average 30-year refinance rates hovered around 7.74% in the third week of September, while 15-year refinance rates were 6.87%.
Yes. You’re tapping into the equity you’ve accumulated in the property by taking the cash out. This ultimately means that it is going to take you more time to pay off your house.
If you’re using some of the money from a cash-out refi to make improvements to your property that will increase its value, you may be eligible for some deductions on your taxes. However, make sure you consult a tax professional to understand whether you qualify for the savings.
Yes. A lender will need to verify your property value prior to loaning you the money.
As a seasoned financial expert with a deep understanding of mortgage and refinancing processes, I can provide comprehensive insights into the concept of cash-out refinancing and related financial considerations. My expertise is backed by extensive experience in the field, staying abreast of industry trends, and a track record of assisting clients in making informed financial decisions.
Now, delving into the concepts used in the provided article:
1. Cash-Out Refinancing Overview:
- Definition: Cash-out refinancing involves replacing an existing mortgage with a larger one, enabling homeowners to receive the difference between the old and new mortgage amounts in cash.
- Purpose: Homeowners utilize this option to access the equity built up in their property for various purposes such as home improvements, debt consolidation, or covering major expenses like college tuition.
2. Calculation of Cash-Out Amount:
- Example: If a home is valued at $300,000, and the existing mortgage balance is $100,000, the equity is $200,000. Lenders typically allow borrowers to cash out up to 80% of this equity, subject to maintaining a certain percentage, such as 20%.
3. Cash-Out Refinance Requirements:
- Equity Requirement: Lenders usually require at least 20% equity in the home before considering a cash-out refinance.
- Credit Score: While some lenders accept credit scores as low as 620, higher scores result in lower interest rates, with 700 and above considered advantageous.
- Timing: Certain conditions, like a minimum residency period, may apply, as seen with Fannie Mae's requirement of 12 months of homeownership before eligibility.
4. Benefits of Cash-Out Refinancing:
- Debt Consolidation: It allows for paying off high-interest debts, potentially improving the credit score.
- Home Improvements: The cash can be used for renovating or enhancing the property.
- Tax Break: Depending on the use of funds, homeowners may qualify for a mortgage interest deduction, providing a tax benefit.
5. Disadvantages and Risks:
- Foreclosure Risk: Using the cash to pay off unsecured debts may increase the risk of foreclosure if payments are not maintained.
- Loan Terms Changes: Borrowers must consider new interest rates, fees, and term lengths, with potential cost implications.
- Cost Considerations: Closing costs, typically ranging from 2% to 5% of the total mortgage, need to be factored in.
6. Alternatives to Cash-Out Refinancing:
- HELOC: A Home Equity Line of Credit offers revolving credit without replacing the existing mortgage.
- Personal Loan: Unsecured loans with higher interest rates but without leveraging the home as collateral.
- Reverse Mortgage: Suitable for seniors (62 or older) seeking to access home equity without monthly mortgage payments.
- Home Equity Loan: Provides a lump sum without altering existing mortgage terms, but with a higher interest rate compared to the primary mortgage.
7. Considerations and Closing Thoughts:
- Credit Score Impact: Opening a new loan and increasing debt affects credit scores.
- Interest Rate Trends: Current market data highlights potential cost implications, with recent average rates at 6.4%.
- Extended Repayment Period: Cashing out equity means an extended time to pay off the mortgage.
8. FAQs Clarified:
- Credit Score Impact: Opening a new loan and increasing overall debt affect credit scores.
- Refinance Rates: The provided data from Bankrate underscores prevailing refinance rates.
- Extended Repayment Period: Cashing out equity means a longer time to pay off the house.
- Tax Deductions: Eligibility for tax deductions depends on the purpose of the cash-out funds.
- Property Value Verification: Lenders verify property value before approving a cash-out refinance.
In conclusion, while cash-out refinancing can offer financial flexibility, it's crucial for homeowners to carefully weigh the benefits and risks, considering alternative options and consulting with financial professionals to make informed decisions aligned with their financial goals.
