You have hefty financial goals or need to make a big-ticket purchase but don’t quite have the cash on hand. A cash-out refinance could be an option if you have a sizable amount of equity in your home. It lets you convert your equity into cash, and you won’t have to worry about managing a second mortgage.
Read on to learn more about how these mortgages work, how they can be used and what’s needed to qualify. You’ll also discover key benefits and drawbacks to help you decide if a cash-out refinance is a good fit.
What Is a Cash-Out Refinance?
A cash-out refinance is a type of home loan product that swaps out your current mortgage for a mortgage, typically with different terms than you currently have. The new mortgage balance is larger as it includes the amount of home equity you pull out.
How Does a Cash-Out Refinance Work?
The lending process begins with you getting preapproved by the lender. Next, the lender requests an appraisal of your home to get a concrete idea of its worth. This figure, along with your credit rating and overall financial profile, helps determine how much you’re approved for.
Once you receive the final approval, you will head to the closing table to seal the deal. The lender will also pay off your existing mortgage balance, and you will commence repayment with the new lender. The remaining loan proceeds will be sent to you electronically.
What Can You Use a Cash Out Refinance For?
You’re free to receive the loan proceeds from a cash-out refinance however you see fit. Most homeowners use these funds to make costly repair or renovation projects that substantially improve the value of their homes, consolidate high-interest credit card debt or cover other big-ticket purchases. Others use the funds to pay for higher education expenses, start businesses, invest them or create a cash stash.
What Are the Benefits of a Cash-Out Refinance?
A cash-out refinance offers several financial benefits to be aware of.
Access to a Lump Sum of Funds
With a cash-out refinance, you have the ability to access cash that can be used for a variety of purposes. This can provide you with the funds needed for home improvements, education expenses or other significant investments.
Lower Interest Rates
Another potential advantage of a cash-out refinance is securing a lower interest rate than your original loan. This can occur when market rates have decreased since you took out your original mortgage, saving you a considerable amount in interest over the loan term.
Predictable Payments
Switching to a fixed-rate mortgage through a cash-out refinance can provide more predictable monthly payments, which can help you manage your housing costs more effectively.
Tax Advantages
Under certain conditions, you might be eligible for tax deductions on the interest paid, particularly if you use the cash to make substantial home improvements. Be sure to consult a tax advisor to learn more.
Possibility to Improve Your Credit Score
By using funds from a cash-out refinance to pay down credit card debt, you can potentially improve your credit score. Lowering your credit utilization ratio is a key factor in credit scoring, and using a lump sum to pay off revolving debt can help in this area. However, it’s crucial to avoid accruing additional high-interest debt after doing so.
What Are the Downsides of a Cash-Out Refinance?
It’s also vital to be aware of the downside that comes with these mortgage products.
Possibility of Increased Debt
The lure of accessing a large sum of money from your home equity could convince you to borrow more than you actually need. And you could end up with a higher debt load than you started with.
Potential for Higher Overall Costs
Although you might initially secure a lower interest rate, the borrowing costs could be substantially higher due to the larger loan amount. These costs can include higher interest payments over the life of the loan, along with closing costs ranging from 2 to 6% of the loan amount.
Risk of Losing Your Home
It’s vital to remember that a cash-out refinance, like any other mortgage, is secured by your home. If your financial situation changes and you cannot meet the new mortgage payments, you risk foreclosure.
How to Qualify for a Cash Out Refinance
Each lender has unique eligibility guidelines, but it’s worth understanding the general requirements before applying for a cash-out refinance.
Debt-to-Income (DTI) Ratio
Your DTI ratio is a key factor lenders consider. It measures your total monthly debt payments against your gross monthly income. Generally, a DTI ratio of 43% or lower is needed, although some lenders may allow a higher ratio.
Loan-To-Value (LTV) Ratio
The LTV ratio represents the current loan amount in relation to the appraised property value. A maximum LTV ratio of 80% is standard for most lenders, meaning you need at least 20% equity in your home to qualify.
Credit Score
A strong credit score is also essential to getting the best deal on a cash-out refinance. Most lenders require a minimum score of around 620 for a cash-out refinance, but a 740 or higher is even better.
Home Equity
You must have sufficient home equity for a cash-out refinance. This differs from a standard home equity loan as you are adjusting your primary mortgage. The equity in your home must typically be more than 20% after the cash-out amount has been subtracted.
Property Requirements
Your property must meet certain property requirements to qualify. It needs to be your primary residence, in good condition and able to pass an appraisal.
Loan Limits
Conforming loan limits are set by the Federal Housing Finance Agency (FHFA). The maximum cash-out refinance loan amount adheres to these limits, which typically increase annually based on changes in the housing market.
How to Get Started with Cash Out Refinancing
When you are ready to apply for a cash-out refinance, here’s how to move forward:
- Step 1: Determine your eligibility. You typically need a good to excellent credit score, a reasonable DTI, and at least 20% equity in your home to qualify.
- Step 2: Shop for lenders. Contact multiple lenders to analyze interest rate terms potentially available to you.
- Step 3: Inquire about fees. Understand all associated costs, including closing costs, typically ranging from 2% to 6% of the loan amount.
- Step 4: Prepare documentation. Gather all necessary financial documents, such as recent pay stubs, tax returns and bank statements.
- Step 5: Apply for the loan. Complete the application and work with a lender to submit any additional documents they need to process your application.
- Step 6: Get an appraisal. The lender will require a professional appraisal to determine your home’s current market value.
- Step 7: Receive the final approval and close the loan. Once approved, you’ll attend a closing meeting to sign the new loan documents.
Possible Alternatives to a Cash Out Refinance
If you’re looking to tap into your home equity without opting for a cash-out refinance, consider the following options:
- Home equity loan: Also known as a “second mortgage,” it allows you to borrow a lump sum against your home’s equity at a fixed interest rate. Payments are made over a set term, separate from your primary mortgage.
- Personal loan or line of credit: If you don’t want to use your home as collateral, personal loans or lines of credit are unsecured borrowing options.
- Home equity line of credit (HELOC): It is a revolving line of credit with a variable rate that lets you borrow against your home equity as needed during the draw period. The line replenishes as you make payments toward the principal, and you’ll only pay interest on the amount you borrow.
Conclusion: Determining Whether Cash Out Refinancing Is Right for You
When considering a cash-out refinance, evaluating your financial situation is essential. Taking out a new loan that’s larger than your current mortgage offers you access to extra cash, but it also increases your debt. Extending your loan term could also mean more interest paid over the loan term.
Be sure to weigh your long-term financial goals and immediate financial needs to make an informed decision.
FAQs About Cash Out Refinance
Closing costs typically range between 2% and 6% of the loan amount. So, for a loan of $200,000, you could expect to pay between $4,000 to $12,000 in closing costs. These costs can include lender fees, appraisal fees, and title insurance. It’s important to factor in these expenses and conduct a cost-benefit analysis to decide if a cash-out refinance is a smart financial move.
Yes, you must pay back a cash-out refinance. The amount you receive from a cash-out refinance becomes part of the principal balance on the new mortgage. Your monthly payments will be recalculated to include the amount of equity you pull out.
