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Cash-out Refinance
In simple terms, it means that you take a new mortgage on your house to replace the existing mortgage. The new loan is bigger and you get to keep the difference between the existing and the new mortgage.
In a sense, you’re cashing out the equity you have built in your home. Whatever is the difference between the new loan and the outstanding balance on the existing mortgage, you get to keep that in cash. It is your money and you can use it for any purpose including debt consolidation, home improvement or any other kind of financial need.
You will now be responsible for repaying the bigger loan that will most likely have different terms. This is why you need to carefully consider the various pros and cons of a cash-out refinance before making a commitment.
How Does it Work?
When you opt for cash-out refinance, you are essentially taking a new mortgage on your home and that new mortgage comes with different terms. Refinancing is used for a variety of purposes.
If the interest rate on the new mortgage is lower, refinancing is a good option. You could also modify the mortgage length. Adding or removing a borrower could also be a reason to get refinancing. Having said that, you can accomplish all of these goals without making any changes to the borrowed amount.
On the other hand, a cash-out refinance means a new mortgage with an amount that is more than the current outstanding mortgage.
Cash Out is the term used to refer to the difference between the amount you currently owe and the new loan amount. The amount of cash you will get depends on the home equity you have and the value of your home as compared to the outstanding mortgage amount.
Let’s take an example.
If your home has a valuation of $300,000 and the remaining mortgage balance is $150,000, you have an equity of $150,000. You now have the option of refinancing the outstanding $150,000 loan for $230,000 and you get to keep the difference of $80,000 in cash.
Since the amount of borrowing with cash-out refinance is dependent on the homeowner’s equity, the lender will get an appraisal to ascertain the current value of your home.
In case there has been a significant increase in the prices of properties in your area, your property may be valued at a much higher price than you paid. It will translate to an increase in the amount of money you could borrow.
Most lenders require borrowers to have at least 20% equity in the house though this percentage varies by lender and it also depends on the type of loan. In the case of VA loans, borrowers are allowed to cash out 100% of their equity.
Requirements for Cash-Out Refinance
You will have to meet the lender requirements to be eligible for a cash-out refinance. The eligibility varies and this is why it’s better to get estimates from several lenders to find out the best offer for you. However, most lenders have certain minimum qualifications as outlined below:
Debt to income ratio — This ratio is used to determine the amount of money you have left after paying your existing debt which includes the current mortgage amount. Your total outstanding debt as a percentage of the gross monthly income is DTI. Lenders usually approve borrowers with a maximum DTI of 45%.
Credit score — Needless to say, higher credit score translates into lower interest rates. As far as qualification is concerned, borrowers with a low score of 620 might also qualify.
Home equity level — In most cases, potential borrowers are required to have a minimum of 20% equity in their home to qualify for refinancing. In simple terms, you should own at least 20% of the latest appraised value of your property.
Seasoning — A potential borrower should have owned the property for a period of at least six months before they become eligible for a cash-out refinance. The amount of equity they have in the property does not matter.
There are certain exceptions for inherited property or a legal award. The seasoning requirement also applies to VA loans. If you have an FHA loan, the seasoning requirement is 12 months. In simple terms, you should have owned the home for a period of at least 12 months before you become eligible for a cash-out refinance.
Pros
Interest rate savings — Typically, the interest rate for cash out refinancing is higher than interest rate for a purchase loan but there is a possibility of lowering the mortgage rate.
For instance, a 30 year fixed rate mortgage in 2018 may have an interest rate as high as 4.94%. On the other hand, interest rates are considerably lower these days. Having said that, it would make more sense for you to opt for a rate and term refinance if your only goal is to lower your mortgage interest rate and you have no need for extra cash.
Consolidating loans — As you are refinancing your home, you will have to make only one loan payment each month. If you want to leverage your home equity, the only other way is to get a second mortgage.
Get cash — If you have a major expense coming up such as college tuition or a home renovation project, you could use cash out refinancing. It allows you to borrow a lot more money as compared to your credit card or a personal loan.
Debt consolidation — Outstanding credit card debts usually have a very high interest rate. You could use cash out refinancing to pay off high interest rate debt and save a lot of money in interest.
Improve your credit score — You may also use cash out refinancing to improve your credit score. If you have outstanding credit card debt, use the money from refinancing to pay the debt in full. It will help you bring down the credit utilization ratio.
Cons
Risk of foreclosure — When you take out a mortgage, your home is the collateral. If you miss payments, there is a real risk of losing your house.
Keep in mind that cash out refinancing is against your house as collateral which makes it is a secured debt. On the other hand, college tuition or credit card debt is unsecured debt. Using secured debt to pay off unsecured debt is not recommended. If you fail to make the payment on time, there is a possibility of you losing your home.
New terms for mortgage — You are taking on a new mortgage which is going to have different terms as compared to the original mortgage. This is why you need to double check the fees you have to pay and the interest rate before agreeing to the new terms.
You should also calculate the total interest you will have to pay over the term of the loan. If you are refinancing to a new 30 year mortgage, it could mean adding years of repayment which will come with a huge amount of interest payment even after lowering the existing interest rate.
Takes some time — It might take a few weeks to get your new mortgage approved. It won’t take as long as a new purchase loan but it takes time. If you need money in an emergency for some reason (could be roof replacement due to water damage), cash out refinancing might not be the best option.
There are substantial closing costs — A cash-out refinance also has closing costs which is the case with any refinancing loan. Typically, these closing costs are in the range of 2% to 5%. For a $300,000 refinancing, it could mean closing costs ranging from $6000-$15,000 which is a big amount.
Private mortgage insurance — If the cash out refinancing is for an amount that is more than 80% of house value, the lender will require you to have private mortgage insurance. For instance, if the house is appraised at $300,000 and you are refinancing an amount in excess of $240,000, the lender will require you to have PMI.
Typically, the cost of PMI ranges from 0.55% to 2.25% of the loan amount annually. Keep in mind that it is an annual payment. If you take a new mortgage for $240,000, the PMI will cost $2400 each year.
Cash out Refinancing Alternatives
You don’t always need a cash-out refinance to take advantage of home equity. There are several other options such as a home equity loan and home equity line of credit. You may use these options to borrow against your existing home equity.
Both these options are a second mortgage or a junior lien. These loans are in addition to the primary mortgage. A home equity loan allows you to borrow a lump amount which isn’t that different from a cash-out refinance. However, it doesn’t affect the existing interest rate.
On the other hand, a home equity line of credit offers more flexibility. It’s a line of credit and you could borrow as much amount as you need.
Both these options have lower closing costs. However, it is a second mortgage which typically has a higher interest rate as compared to a cash-out refinance.
Is It a Good Idea to Take a Cash-Out Refinance?
A cash-out refinance is the right option if you’re able to get a lower interest rate on the new loan. Also, you should have a clear idea about how you will use the money.
You shouldn’t be using this loan for buying a new car or for a vacation as you won’t get any return on your money. A smarter way to use this money is for a home renovation project as it will allow you to rebuild the equity you have just taken out.
In any case, a cash-out refinance requires you to put your home as collateral and you need to make the payments on the new mortgage loan in full and on time, always.