Cash-Out Refinancing: How It Works and When It is the Right Option

Cash-Out Refinancing: What Is It?

Cash-out refinancing is the process of replacing your existing home loan with a higher mortgage loan. It allows you to leverage your home’s equity and access the difference between your current loan and the new loan in cash. This cash can be utilized for almost any purpose including consolidating a high-interest loan, remodeling your home, or achieving other financial goals.

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How does cash-out refinancing work?

Cash-out refinance works pretty much the same way as a rate-and-term mortgage refinance where you trade in your current loan with a new one of the same principal amount but for a shorter repayment period or at a lower interest rate or both. While you can do the same in a cash-out refinance, you also have the option to withdraw some specified amount from the equity in your home in cash.

According to Greg McBride, CFA, Bankrate chief financial analyst, cash-out refinancing is ideal if you can get a lower interest rate on your primary mortgage and properly use the funds that you take out.

When you complete a cash-out refinance, you typically pay more interest since you are raising the loan amount, and same as with other loans, you will need to pay for closing costs. All in all, the process of a cash-out refinance will be similar to when you were applying for your first mortgage – choose a lender, submit an application, provide all the required documentation, wait for approval, and finally wait for closing.

Below is a brief guide on how to prepare for a cash-out refinance:

1. Find out the minimum requirements of the lender

Different lenders will have different requirements for qualifying for cash-out refinancing, and the majority have a minimum credit score requirement. Other common requirements include a minimum of 20% equity in your home and a debt-to-income ratio below a certain percentage. You need to carefully consider these requirements when choosing a lender.

2. Figure out the amount you need

There are many reasons that you may consider a cash-out refinance. As stated earlier, the funds you take out can be used for virtually any purpose. It is highly important that you first determine why you want a cash-out refinance to ensure that you borrow the right amount that you need. For instance, in case you are planning on consolidating debt, refer to your personal loan and credit card statements or information regarding other debt obligations and calculate how much you owe. If you are planning a home renovation, contact a few contractors to get rough estimates for labor and materials.

3. Make sure you have all the information required when applying

After finding the lender with the best rate and terms, you need to prepare all the necessary financial information. This will mainly include information relating to your assets, income, and debt. Also, note that you might be required to submit additional documentation as the lender processes your application.

Example of How a Cash-Out Refinance Works

Let’s say that your home’s current market value is $300,000 and you have an outstanding mortgage balance of $100,000, here, you will have $200,000 in home equity. And let’s suppose that refinancing your current mortgage will get you a lower interest rate, and you are planning on using your funds to renovate your kitchen and bathrooms.

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Given that lenders typically require you to have at least 20% equity in your home (though there are exceptions) after a cash-out refinance, you will need to have a minimum of $60,000 in home equity or be able to borrow up to $140,000 in cash. Also, note that you will need to settle the closing costs including such as the appraisal fee meaning that the final amount might be lower.

Key Things to Keep in Mind About Cash-Out Refinancing

You can’t borrow 100% of the equity in your home – A majority of lenders stipulate that you maintain no less than 20% equity in your home in a cash-out refinance. However, in the case of a VA cash-out refinance you can withdraw 100% of all your equity.

You might get a completely different loan – Given that you are trading in your current loan with a new loan, the loan terms might be different from the original. For example, you might end up with a lower or higher interest rate and monthly payments, or a shorter or longer loan term.

Your home will need to be appraised – As the amount you can borrow in a traditional cash-out refinance is dependent on how much equity you have, lenders will require a home appraisal.

You won’t receive the cash immediately – After closing, the lender is typically required to give you 3 days to pull out of the refinance if the need arises. Due to this, you will have to wait a few days before you get the cash in your bank account.

You handle the closing costs – Same as with your first mortgage, a cash-out refinance carries closing costs which include appraisal fees, lender fees, among other expenses. It is therefore crucial that you carefully consider what a cash-out refinance will cost you to avoid unnecessary expenses, especially if you are taking out a large amount.

How Much Can I Get in a Cash-Out Refinance?

Even though lenders allow you to take out up to 80% of the value of your home, the final amount will vary depending on a number of factors such as your credit score, type of mortgage, and the kind of property (for instance single-family, duplex property, etc.).

Lenders who provide Federal Housing Administration or FHA-insured loans may in some cases offer FHA cash-out refinancing that lets you borrow up to 85% of your home’s value. The U.S. Department of Veterans Affairs (VA) guaranteed cash-out refinance loans allow applicants to borrow up to 100% of their home’s value.

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What can the money be used for?

The proceeds from a cash-out refinance can be used for any purpose. Here are some of the common reasons that homeowners opt for a cash-out refinance:

Home improvement projects – You can utilize the funds to complete your home improvement projects. If you are able to substantially improve the value of your home, you will deduct mortgage interest from your taxes.

Investment – Another reason to consider cash-out refinancing is to get capital to invest in your retirement or acquire an income property.

Consolidate debt – Compared to other kinds of debts such as credit cards, cash-out refinance loans typically have lower rates. You can use funds from a cash-out refinance to settle the high-interest debts and instead pay off the loan with one low-cost monthly payment.

Pay for college education – It’s no secret that college education is costly. Given that the refinance rate is typically much lower than the rate for a student loan, using the funds from a cash-out refinance to pay college makes a lot of sense.

What Are the Fees for a Cash-Out Refinance?

Typically, the closing costs of a cash-out refinance range from 3-5%of the new loan amount. The closing costs normally cover the lender origination fees and appraisal fees for the home’s evaluation. It is beneficial to compare multiple lenders to ensure that you are getting the best rates and terms.

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While you can keep off upfront closing costs by rolling the costs of the loan into your new mortgage loan, you will likely end up getting a higher interest rate. In addition, refinancing at a higher interest rate or obtaining another 30-year loan might mean that you incur more in total interest. Our refinance calculator allows you to figure out the numbers and determine whether you are making the right decision.

Benefits of a Cash-Out Refinance

There are many advantages to cash-out refinancing, especially if you are taking out a large sum of money:

It allows you to lower your interest rate – This is perhaps the main reason the majority of borrowers refinance, and it makes a lot of financial sense when it comes to cash-out refinancing. This is because it allows you to significantly lower the interest rate you have to pay when taking out a bigger loan.

Lower borrowing costs – As the rates of mortgage refinances are usually lower than the rates for personal loans such as credit cards and home improvement loans, this makes cash-out refinancing is a less costly kind of financing. Despite the closing costs, this can be particularly beneficial if you require a large amount of money.

Lets you boost your credit score – If you use the proceeds from a cash-out refinance to pay off your existing debts, you could benefit from an improved credit score in case your credit utilization ratio reduces. Credit utilization is the ratio of how much you are borrowing to how much is available to you. This is one of the key factors that determine your credit score.

You can take benefit from tax deductions – If you are planning on using the funds for home improvement projects and you are able to meet IRS eligibility requirements, you can gain interest tax deductions.

Downsides of a Cash-Out Refinance

There are instances where cash-out refinancing isn’t an ideal option. The following are some of the cons of a cash-out refinance:

It may cause your rates to increase – One of the key goals of cash-out refinancing is to gain a lower interest rate. However, if a cash-out refinance causes your rate to go up significantly, you should avoid it.
You may need to pay for PMI – There are lenders that will let you take out as much as 90% of your home’s equity, however, if you choose to go this route you will need to pay for private mortgage insurance (PMI) until you get back under the 80% equity threshold. This means that you will incur higher overall borrowing costs.

You may end up having to make payments for decades – When considering a cash-out refinancing, it is important to ensure that this option doesn’t prolong your debt repayment when you could have otherwise paid it off much faster and at a lower cost. McBride advises that since the repayment of whatever amount you will take out will be spread over 30 years using the funds to pay off a higher-cost credit card debt may yield the expected results. Using the cash for home improvement is a much smarter move.

It increases your risk of losing your home – Regardless of your purpose of the cash-out refinance, in case you fail to pay the loan on time, you can end up losing your home through foreclosure. Ensure that you only take out the amount that you absolutely need and that you are using it for something that will improve your financial situation.

It presents the temptation of using your home as a piggy bank – Using funds from a cash-out refinancing to go on expensive vacations or shopping sprees shows a serious lack of control over one’s spending habits. In case you are having trouble getting your spending or debts under control, it is a good idea to seek help from nonprofit credit counseling agencies.

Cash-Out Refinancing and Taxes

Cash-out refinance loans are subject to mortgage interest tax deductions provided that you are utilizing the funds to improve your property. Here are some recommended home improvement projects:

  • Home security system installation
  • Window replacement with storm windows
  • Fence installation
  • Adding a new bathroom or bedroom
  • Roof improvement projects
  • Adding a heating or central air conditioning system

Cash-Out Refinancing vs. Home Equity Loan

While both home equity loans and cash-out refinance loans allow you to tap your home’s equity, there exist some significant differences between the two. A cash-out refinance involves settling your current loan with a new loan of a higher amount and receiving the difference in cash. On the other hand, a home equity loan is a second loan and does not replace your first mortgage loan. In addition, a home equity loan typically has a higher interest rate than a cash-out refinance.

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