A cash-out refinance is a practical mortgage option that allows you to convert home equity into cash. The process involves taking out a new mortgage for an amount greater than your previous balance, and the surplus is provided to you in cash.
Refinancing is a common practice in real estate, offering the opportunity to replace an existing mortgage with a more favorable one. This can lead to reduced monthly payments, a lower interest rate, and modifications to loan terms. In the case of a cash-out refinance, you not only benefit from these advantages but also gain access to additional funds by tapping into the equity in your home.
How a Cash-Out Refinance Works
A cash-out refinance involves using your home as collateral to secure a new loan and obtain additional cash. This process creates a new mortgage with a higher amount than your current outstanding balance. Accessing funds through the equity in your home provides a straightforward solution for emergencies, expenses, or personal desires.
For those considering a cash-out refinance, the initial step involves finding a lender willing to collaborate. The lender evaluates the existing mortgage terms, the amount required to settle the loan, and the borrower’s credit history. Based on this assessment, the lender extends an offer through underwriting analysis. The borrower accepts a new loan that pays off the previous one and commits to a revised monthly installment plan. Any surplus amount beyond the mortgage payoff is disbursed as cash.
Unlike a standard refinance that only reduces monthly payments, a cash-out refinance provides the borrower with cash to use as needed. Many choose to allocate these funds for significant expenses, such as medical or educational costs, debt consolidation, or building an emergency fund.
It’s important to note that a cash-out refinance reduces home equity, elevating the risk for lenders. Consequently, closing costs, fees, or interest rates may be higher compared to a standard refinance. However, borrowers with specialized mortgages like U.S. Department of Veterans Affairs (VA) loans, including cash-out loans, often find more favorable terms, with lower fees and rates than non-VA loans when refinancing.
- Determining Cash Needs: Identify the required cash amount for specific purposes like home renovations or debt consolidation to avoid unnecessary borrowing.
- Qualification Check: Ensure eligibility by meeting common requirements, such as a credit score of at least 620 and maintaining a minimum of 20% home equity.
- Rate Comparison: Explore cash-out refinance rates from at least three lenders to secure the best deal. If current rates don’t offer savings, reconsider tapping into home equity.
Pros and Cons of a Cash-Out Refinance
Astute investors monitor interest rates and seize opportunities to refinance when rates are dropping. Refinancing options, although beneficial, entail additional costs and fees, emphasizing the importance of timing. While this choice often offers lower interest rates than unsecured debts like credit cards or personal loans, the risk involves potential home loss if mortgage payments become unmanageable or property values decline, leading to negative equity.
Assessing the worthiness of the cash need against the risk of home loss is crucial. If the purpose is to settle consumer debt, it’s advisable to address spending habits to avoid a cycle of debt reloading. The Consumer Financial Protection Bureau (CFPB) provides helpful guides to evaluate whether refinancing is a suitable decision for individual circumstances.
A cash-out refinance provides borrowers with the advantages of a standard refinance, such as a lower interest rate and potential modifications. Additionally, borrowers receive a cash payout, allowing them to pay off high-interest debt or finance significant expenses. This option is especially advantageous during periods of low interest rates or in times of crisis, as experienced in 2020–21 during global lockdowns, where lower payments and extra cash proved valuable.
Cash-out refinance example
Consider a scenario where your current mortgage balance is $100,000, and your home is valued at $300,000, resulting in $200,000 in home equity. If you aim to use this equity for a $120,000 kitchen and bathroom renovation, you must maintain at least $60,000 in equity (20% of $300,000).
Opting for a cash-out refinance, you can extract up to $140,000. Let’s say you decide to refinance, taking out $130,000 in cash, replacing the old $100,000 mortgage with a new one at $230,000 and a revised interest rate. With closing costs of 1% ($2,300), you’ll receive $127,700 in equity funds.
How much cash can you get with a cash-out refinance?
With conventional loans, cash-out refinances usually permit borrowing up to 80% of a home’s value, though the limit varies by property type. In the case of multifamily homes, the borrowing threshold is typically 75%. FHA loan cash-out refinances may allow borrowing up to 80% of the home’s value, while VA loan cash-outs could potentially access the entire home equity.
Rate-and-Term vs. Cash-Out Refinance
Borrowers can choose between two primary refinancing options. A rate-and-term refinance focuses on securing a lower interest rate or adjusting the loan term, without altering the mortgage’s fundamental structure. This is suitable for those seeking to benefit from current lower interest rates or adapt to a different loan term based on changed circumstances.
On the other hand, cash-out refinancing serves a distinct purpose – obtaining tax-free cash. The borrower receives the surplus amount between the original and refinanced mortgages in cash at closing, typically 45 to 60 days after application. However, it comes with higher interest rates, additional costs like points, and elevated underwriting standards. A strong credit score and a lower loan-to-value ratio can enhance the chances of securing favorable terms in cash-out refinancing.
Cash-Out Refinance vs. Home Equity Loan
In a cash-out refinance, you replace your existing mortgage with a new one, paying off the current loan. In contrast, a home equity loan involves taking out a second mortgage alongside your original, resulting in two separate creditors and potential claims on your property.
Home equity loans generally have lower closing costs compared to cash-out refinances. Opting for a home equity loan can be advantageous when you need a significant sum for a specific purpose. However, if a cash-out refinance offers a lower interest rate and you plan to stay in your home long-term, it may be a more sensible choice. Regardless of the option, ensure you can comfortably repay the new loan to avoid the risk of losing your home.