Are you saddled down by debt? If so, you may be eligible for a cash-out refinance to make your debt load more manageable. But is this a smart financial move? It depends on your financial situation.
Here’s what you need to know about cash-out refinances, along with their key benefits and drawbacks, to decide if they’re a viable option for meeting your debt payoff goals.
What Is a Cash-Out Refinance?
A cash-out refinance is a type of refinance loan that lets you swap out your current mortgage for a large one and receive the difference in cash. The amount you’re approved for is based on your home’s equity, which is the percentage of your home you own outright.
You can calculate this figure by subtracting the outstanding mortgage balance from the property value.
Can You Cash-Out Refinance to Pay Off Debt?
Lenders do not impose spending restrictions on cash-out refinances, which can be a strategic tool for consolidating credit card debt and other high-interest debt.
Basic Considerations
Before paying off debt with a cash-out refinance, consider the amount of equity in your home to gauge if it’s enough to cover your debts. The amount of cash you can pull out is generally limited to 80 percent of your home equity, so having a cushion is ideal to make this approach worthwhile.
Also, compare the interest rates on your current debts and the cash-out refinance to ensure the latter is lower. And don’t forget to consider closing costs, which are usually two to six percent of the loan amount.
Another important factor to consider is the new loan term. A more extended repayment period means you’ll spend more time paying off your home, and the increase in borrowing costs could be substantial.
Practical Example
Assume you owe $175,000 and have a home worth $350,000. If the lender lets you borrow up to 80 percent of your home’s value, you can get a cash-out refinance of $280,000 ($350,000 * .80).
Once the loan closes and funds, the lender will pay off your current mortgage of $175,000 and disburse the remaining $105,000 to you. You can use these funds to pay off debt or meet other financial goals.
Eligibility and Qualifications for Cash-Out Refinancing
Lenders consider three primary factors when you apply for a cash-out refi.
Debt-to-Income (DTI) Ratio
Your DTI ratio is the percentage of your monthly gross income used to cover debt obligations. Most lenders prefer a DTI under 43 percent, although some offer a bit more flexibility. But if it’s much higher, the lender may assume you’re overextended and deny you a loan.
Credit Score
A strong credit score opens the door to better approval odds and loan terms on a cash-out refi. You can access a cash-out refinance with a score of 620 or higher (or 580 for FHA loans), but a 680 is preferred. Be mindful that your credit score directly impacts your mortgage rate and overall borrowing costs.
Home Equity
As aforementioned, lenders commonly allow you to borrow up to 80 percent of your home’s value, including your current mortgage and the new cash-out amount.
How to Apply for a Cash-Out Refinance
Here’s a breakdown of what to expect when you apply for a cash-out refinance:
- Step 1: Determine eligibility. Calculate your home equity to determine your eligibility for a cash-out refinance. Most lenders want to see at least 20 percent in home equity before considering you for a cash-out refinance.
- Step 2: Check your options. Shop around for rates with different lenders. Compare loan offers to find the best deal on a cash-out refinance.
- Step 3: Apply for a cash-out refi. Submit a formal application with your chosen lender and send over the requested documents. These include recent pay stubs, tax returns, statements of outstanding debts, and proof of homeowners insurance.
- Step 4: Get a home appraisal. During this period, the lender will also order a property appraisal to determine your home value and how much you’re eligible for.
- Step 5: Finalize the transaction. Upon approval, you will attend the closing, pay closing costs (if you opt not to roll them into the mortgage) and sign the loan documents. The lender will then use a portion of the new loan to pay off your old mortgage and send the difference to you.
- Step 6: Repay the new loan. Start making mortgage payments to the new lender. Expect higher monthly payments on the new loan since the new mortgage is higher.
Advantages of Using Cash-Out Refinance to Pay Off Debt
A cash-out refinance could alleviate the added stress that comes with managing pesky debt obligations.
Lower Interest Rates
By opting for a cash-out refinance, you might secure a lower interest rate for your debt. This can reduce your monthly payments to make them work better for your budget. And you’ll likely lower your borrowing costs significantly.
Consolidation of Payments
Instead of paying several creditors each month, you can combine several debts into a single payment. Doing so streamlines the debt repayment process and simplifies your monthly budget. Plus, you can eliminate the frustration that comes with juggling multiple bills and incurring penalties or fees if you miss payments.
May Increase Your Credit Score
If you consolidate revolving debts, including credit cards and lines of credit, your utilization ratio will drop. In turn, your credit score could improve since the total amount owed to creditors (which includes this figure) accounts for 30 percent of your FICO score. This can be particularly beneficial if you plan to access other forms of credit in the future, as a higher credit score may qualify you for more favorable borrowing terms.
Disadvantages of Using Cash-Out Refinance to Pay Off Debt
There are also a few key drawbacks to keep in mind when deciding if this approach is best.
Potential for Higher Overall Interest
A cash-out refinance could mean a lower interest rate on your debts, but this doesn’t necessarily translate to savings. Depending on the new term and rate, you could pay far more in interest over the life of the loan.
Risking Your Home
A cash-out refinance turns unsecured debts into secured debts, and you risk losing your home if you can’t keep up with the new mortgage payments. If market values dip, you could also end up with an underwater mortgage (or owing more than your home is worth). This is a major drawback if you plan to sell your home soon.
Extending Pay Off Period
By refinancing your existing mortgage for a larger amount and longer term, you’re essentially extending the time it will take to pay off your home. A cash-out refinance may provide short-term relief, but the long-term impact could be costly to your finances, as you’ll pay far more in interest on the new mortgage.
How to Know If a Cash-Out Refinance Is The Right Move for You
It depends on your unique financial situation and goals. A cash-out refinance could be the right move if:
- You will have at least 20 percent in home equity after the transaction is complete.
- You want to consolidate high-interest debt to make your payments more manageable.
- You have good or excellent credit and can qualify for a cash-out refinance with a competitive rate.
- You’ve calculated closing costs and determined that the long-term savings outweigh these initial fees.
- You plan to stay in your home for a period that’s past the break-even point.
However, you may want to explore other options if:
- Your budget is tight, and the new mortgage payment is significantly higher, potentially putting you at risk of foreclosure.
- You’re approved for less favorable terms than you already have due to current market conditions or credit challenges.
- Your DTI is on the higher end, and the lender isn’t offering you favorable terms.
- You plan to move soon, and the closing costs will easily outweigh the benefits of refinancing.
- You’re not disciplined enough to stop using the credit cards you pay off when consolidating.
Conclusion: Assessing Your Financial Situation
Assess your financial situation to decide if a cash-out refinance makes financial sense. You can also use a cash-out refinance calculator to run the numbers before applying for a new loan.
