What Is a Cash-Out Refinance?
Cash-out refinancing involves the replacement of your current mortgage with a new, bigger mortgage. The difference between the new and old loan amounts is repaid to you in cash at closing.
Cash-out refinancing allows you to utilize the equity in your property for any reason. And it is a fantastic method to access a significant amount of money at extremely cheap interest rates.
The Mechanics of a Cash-Out Refinancing
A cash-out refinance allows you to access your home equity while simultaneously refinancing your mortgage.
With a cash-out refinance, you obtain a new loan larger than your current mortgage. The new loan amount is used to pay off your existing mortgage, and any remaining balance is repaid in cash.
A few essential points about cash-out refinancing:
- Cash-out refinancing rates are more than conventional mortgage refinancing rates.
- Your refinancing rate is determined by your credit profile and the amount of cash you withdraw.
- Typically, you can withdraw up to 80% of your home’s value.
- Your new loan will be greater than your previous one, so you will ultimately pay more mortgage interest.
- As mortgage rates tend to be lower than personal loans and credit cards, cash-out refinancing might be a preferable option to fund major costs.
There are no restrictions on how the proceeds from a cash-out refinancing can be used.
Tom Trott, branch manager at Embrace Home Loans, explains that this additional money can be utilized for various objectives, including home upgrades, debt consolidation, and other customer needs or desires.
However, because your property backs the loan, you should generally invest the money in something with a high rate of return, such as home improvements or consolidation of high-interest debt.
Cash-Out Refinancing Illustration
Refinancing with cash-out involves obtaining a new, bigger mortgage loan to pay off the previous debt.
At closing, you receive a check for the amount remaining after paying off your initial mortgage. This is the cash-out section.
Here is an illustration of how cash-out refinancing operates:
- Home value: $350,000
- Current mortgage balance:$250,000
- loan sum after refinancing: $280,000
- Cash-out: $30 000 (minus closing costs)
In the preceding example, the new loan must be utilized first to pay down the previous mortgage.
The remaining loan balance of $30,000 is the amount you are cashing out.
The closing expenses for a cash-out refinancing are typically between 3 and 5 percent of the loan amount.
When you refinance, you may roll closing expenses into your loan balance and avoid paying them upfront. However, rolling closing fees into your loan may result in interest payments over time; therefore, you should analyze the long-term expenditures before electing to do so.
How Much Cash Can You Get With a Cash-Out Refinance?
You can borrow up to 80 percent of your home’s value for a typical cash-out refinancing.
Lenders refer to this proportion as the “loan-to-value ratio” or LTV.
Remember that you must reduce the amount you owe on your mortgage to determine how much cash you can remove.
The following is an illustration of how a standard cash-out refinancing works:
- Home value: $400,000
- $320,000 is the maximum conventional refinancing loan amount (80% of property value)
- Currently outstanding mortgage balance: $250,000
- Maximum withdrawal: $70,000
In the preceding illustration, the homeowner begins with $150,000 in home equity. (Because the value of the residence is $400,000 and the loan debt is $250,000)
However, the maximum amount this borrower might withdraw is $70,000, as the homeowner must leave 20% of the home’s value intact.
If the homeowner already had a second mortgage secured by the property’s equity, such as a home equity line of credit, the lender would deduct the amount of that loan from the possible cash-out.
Lenders restrict the amount of equity they may withdraw to protect themselves against losses in the event of failure.
Rates for Cash-Out Refinancing
Cash-out refinances rates are typically 0.125% to 0.5% higher than no-cash-out refinance rates.
As with other mortgage loans, your cash-out refinance interest rate will depend on your situation.
“The rate you pay will depend on your loan-to-value (LTV) ratio, credit score, and in certain situations, loan size,” explains Carol Lynn Upshaw, a senior mortgage originator with Hyperion Mortgage.
“Those with higher credit scores — generally above 740 — and lower LTV ratios receive the greatest interest rates,” she says.
Additionally, the more home equity you withdraw, the higher your interest rate will be.
Mortgage Network’s inside sales manager, Ryan Leahy, explains:
“If you borrow 70% of the value of your property, you may pay a 0.125% higher interest rate. If you borrow 80% of your home’s worth, you may pay a quarter-percentage-point-higher interest rate.
Cash-Out Refinancing Prerequisites
To utilize a cash-out refinance, you must qualify for the loan based on your credit, money, and property, just like homebuyers do when obtaining a new mortgage.
Cash-out refinancing criteria vary by lender and loan type. However, you may often anticipate needing the following:
- 20% or more equity in your property
- A fresh valuation to confirm your home’s worth.
- A minimum credit score of 620
- 43% or less debt-to-income ratio (including the new loan).
- Minimum loan-to-value ratio of 80%
- Verification of your work and income
These conditions apply to the vast majority of traditional cash-out refinances.
However, the cash-out refinancing rules for FHA and VA loans differ slightly, as we explain below.
Types of cash-out refinances
There are three primary cash-out refinancing alternatives available to homeowners:
- Conventional loans: A conventional cash-out refinance permits you to borrow up to 80% of the value of your property with a minimum credit score of 620.
- FHA loans: An FHA cash-out refinance enables you to borrow up to 80% of the value of your property. As with any other new FHA mortgage, you will be required to pay upfront costs that are funded into the loan and an annual mortgage insurance premium. Typically, a credit score of at least 600 is necessary.
- VA loans: Many lenders restrict the LTV at 90%. Unless you are a veteran with a service-connected disability, VA cash-out refinancing loans have up-front costs that are incorporated into the loan.
The cash-out refinancing loan that is best for you will depend on your current mortgage and eligibility.
The Closing Procedure
The cash-out refinance procedure resembles a standard mortgage refinance:
- Examine the cash-out refinancing rates and fees offered by several lenders to get the best deal.
- Select a lender and submit a refinancing application.
- Provide evidence, such as pay stubs and W-2 forms.
- Get a home appraisal
- The loan underwriter will examine all of your paperwork and provide you approval for cash-out refinancing.
- Sign the closing paperwork and get paid at closing.
Real estate attorney Rajeh Saadeh explains, “If your property is considered to be of adequate value to support the loan, and if the payback for the old mortgage is less than the amount of your new loan, your refinance loan will be approved and a mortgage closing will be set.”
Remember to include the initial closing procedure stage for a cash-out refinance.
Since cash-out refinance rates are somewhat higher than conventional mortgage rates, and you’re taking out a larger loan than before, it’s crucial to look around and locate the best refinance deal available.
Cash-Out Refinancing Options
Refinancing with cash-out is one of many strategies to liquidate home equity. Other alternatives include home equity loans and lines of credit. These loans are known as “second mortgages” since they are taken out in addition to the original mortgage. This is distinct from cash-out refinancing, which replaces your existing loan so that you retain only one mortgage.
Home Equity Loan vs. Cash-Out Refinance
Similar to a cash-out refinancing, a home equity loan allows homeowners to leverage the equity in their houses.
On the other hand, a home equity loan is a second mortgage that does not replace the first mortgage. Instead, you obtain a second loan secured by the value of your property, which is turned into cash at closing.
A home equity loan is preferable to a cash-out refinance if you do not wish to modify your existing mortgage, maybe because you already have an extremely low-interest rate or are near to paying off the original loan.
HELOC vs. Cash-Out Refinance
Cash-out refinancing and home equity lines of credit (HELOCs) allow homeowners to use the equity in their houses, similar to home equity loans.
In contrast to cash-out refinancing, which provides a borrower with a flat payment, a HELOC is a revolving line of credit that allows homeowners to take funds as required. Additionally, a HELOC is not a new mortgage; upfront closing expenses may not be necessary.
Personal Loan vs. Cash-Out Refinance
A personal loan is a lump sum of money that can be used for any purpose, including consolidation of high-interest debt and large expenditures.
Personal loan interest rates vary substantially among lenders, primarily decided by your creditworthiness. Personal loans are often repaid in monthly installments, comparable to a mortgage.
Personal loan interest rates are typically much higher than mortgage, home equity, and HELOC rates.
Reverse Mortgage vs. Cash Out Refinance
Like a conventional mortgage, a reverse mortgage loan enables homeowners 62 or older with substantial home equity to borrow money using their residences as collateral.
Unlike a conventional mortgage, a reverse mortgage does not need monthly payments. Instead, you borrow against your equity, and the loan is only returned when the property is sold, or the homeowner dies.
If you are considering a reverse mortgage loan, you should discuss your choices with a HUD-approved counselor.
When Does Cash-Out Refinancing Make Sense?
“A cash-out refinancing loan might be a good choice if you qualify for and can obtain a lower interest rate on the new loan than the previous loan,” adds Saadeh.
Refinancing with cash-out allows you to switch from an adjustable-rate loan to a fixed-rate mortgage or to pick a shorter loan term, which can lower your interest payments over time.
And, of course, there’s the closing cash you’ll receive, which might assist you in improving your finances. Upshaw suggests that homeowners utilize their equity withdrawals for:
- Debt consolidation
- Repayment of an existing loan of home equity credit (HELOC)
- Renovating the residence
- Payment of income tax
There are additional wise reasons for cash-out refinancing, such as paying for college.
However, keep in mind that you are creating a new, long-term debt – possibly 15 or 30 years of monthly payments — on which you will pay substantial interest, despite the low rate.
Therefore, experts advocate cashing out your equity only for the above-mentioned critical needs or long-term investments.
Using home equity for low-return investments, such as a vacation or a new automobile, is typically discouraged.
What About Loans for Debt Consolidation?
Debt consolidation may be an excellent method for reducing monthly debt payments and saving money on interest. However, this method is only appropriate for some.
For example, there may be better plans than paying down federal student loans using home equity due to the loss of repayment flexibility.
Additionally, paying off vehicle loans may be costly. With a 30-year cash-out refinance, you’ll still be making monthly mortgage payments in 30 years, which means you’ll still be paying off your auto loan after the vehicle is long gone.
If you are uncertain whether a cash-out refinance makes sense, consult a mortgage lender, broker, or financial adviser who can examine your finances in further detail and advise you on your best course of action.
How a Cash-Out Refinancing Impacts Your Taxes
Borrowers may be eligible for mortgage interest tax deductions if the proceeds from the cash-out refinancing are utilized to improve the property. Some examples of qualified home renovations for mortgage interest tax deductions include:
- Additions to a dwelling
- Security system installation
- HVAC replacement
- Roofing repairs
- Decking and fence assembly