Cash-out refinancing is a process that allows homeowners to refinance their existing mortgage, obtain a new mortgage, and withdraw the difference in cash. This cash can be used for different purposes, such as paying off debt, funding home improvements, or investing in other areas. If you've built up equity in your home over time, cash-out refinancing might be a smart financial move. Prior to deciding, it's important to carefully consider all the pros and cons of the cash-out refinancing process.
What is cash-out refinance and how does it work?
A cash-out refinance is similar to that of a regular mortgage refinance, where you replace your existing loan with a new one, usually at a lower interest rate or for a shorter loan term, or both. The big difference is with a cash-out refinance, you're also able to withdraw a portion of your home's equity in a lump sum. This means that your new loan amount will be higher, but it'll be equal to the amount of equity you're drawing upon.
In terms of a cash-out refinance:
- You need to have at least 20% equity in your home
- You can borrow up to 80% of your home’s current market value
For example, let's say your home is worth $300,000 and you owe $200,000 on your mortgage. If you plan to refinance with cash-out, you can borrow up to $250,000, depending on the lender's policies. The lender gives you the difference between the two loans ($50,000 in this case) in cash.
Keep in mind, with a cash-out refinance, you'll need to pay additional closing costs like appraisal and other fees, which can quickly add up to 3-5% of the total new loan amount. It's important to weigh all costs and benefits before choosing this route.
Why Choose Cash-Out Refinancing?
Let's dive into why you might opt to take this path and what some people use this money for.
- Home improvements: A common use for cash-out refinancing is helping finance home improvements. For example, this money could help you update your kitchen or bathroom, add a new room, or make any other changes that will increase the value of your property.
- Consolidating debt: You might also choose cash-out refinancing if you're looking to consolidate debt. High-interest loans such as credit cards can quickly add up and become overwhelming. If this is your situation, rolling several loans into one with a lower interest rate can be beneficial. (We have an entire section of our website devoted to all things debt consolidation.)
- Education expenses: Another popular reason for refinancing is covering education costs. If you're expecting your child to attend college sometime soon, cash-out refinance might be an option to pay for their tuition without putting too much strain on your finances.
- Emergency expenses: Unexpected expenses often result in financial hardship. In these cases, a cash-out refinance could help ease the burden and provide the funds needed to meet your obligations.
- Investment opportunities: Looking to invest some money but don't have enough saved up? Then cash-out refinancing is an option that might provide working capital. You can use this money as seed money for investments or to start a business.
Pros and cons of cash-out refinancing
Cash-out refinancing can be a good idea to withdraw equity in your home as mortgage rates are still high. However, there are benefits and drawbacks to consider before moving forward:
|You can access your home equity to pay off debt or finance expenses like home improvements.
|It can be expensive in the long run, as it adds years to the mortgage term, and you will pay more interest.
|Interest rates are often lower than what you would get on other loans, like personal loans or credit cards.
|Depending on the loan terms, you may pay closing costs and other fees.
|It's a way to consolidate debt and lower overall payments by rolling multiple debts into one loan with a single amount.
|If you default on the loan, your house is at risk of foreclosure.
|Your payment may be tax-deductible if used for improvements on a primary residence.
|You will be locked into the same interest rate for several years, making it a long-term commitment.
Who Can Qualify for Cash-Out Refinancing?
Now let's discuss the eligibility requirements for cash-out refinancing. These requirements vary a bit from lender to lender, but generally speaking, you can expect to need the following:
- You need a good credit score and history (most lenders want a credit score of at least 580 to qualify for refinancing. To take cash out, this number increases to 620)
- A minimum of 20% equity in your home
- Your debt-to-income ratio should be less than 43%, ideally closer to or above 50%
- You may need additional income or assets to qualify for a larger loan
- The property used as collateral must be your primary residence
In addition, most lenders will require that you have sufficient income to make the payments on the new loan, so it's important to take into consideration all factors before applying for a refinance.
Speaking with a lender who can discuss your situation and help you make an informed decision is encouraged.
How to Cash-Out Refinance
The process of cash-out refinancing is relatively straightforward. Prior to beginning, however, you should determine your goals for the process. . Are you looking to consolidate high-interest debt or finance home improvements? Make sure you have a clear idea of how much cash you need.
So, how does a cash-out refinance work? Here are the basic steps you can expect:
- Gather your financial information and documents: You'll need to have certain documents on hand when applying, mostly related to proving your income and assets. These can include tax returns, pay stubs, bank statements, and proof of assets.
- Shop around for a lender: Compare rates and terms from multiple lenders to find the right fit for you.
- Apply for the refinance: Submit your application with all supporting documentation to the lender of choice.
- Get approved: Once approved, negotiate any last details with the lender before closing the loan.
- Close on the loan: Sign the final paperwork and pay any closing costs with the refinance.
- Start making payments: Begin making payments on your new loan as per the agreed-upon terms.
Risks of Cash-Out Refinancing
Like any other major financial process, cash-out refinancing can come with risks. So, it's crucial to understand the risks of cash-out refinancing before you commit:
- The first thing to consider is the current interest rate environment. The goal of cash-out refinancing should be to lower your interest rate, not raise it. Given current cash-out refinance rates are around 6-6.5%, if you're paying less than that on your mortgage now, you should think carefully about whether it's the right choice for you.
- One of the most significant risks is owing more than your house is worth if real estate values decrease in your area. This can leave you with an underwater mortgage and little options when it comes time to refinance again or sell.
- Another risk is defaulting on your loan. Then, you could lose your home through foreclosure, as your home's equity secures this type of loan.
Finally, consider all costs associated with a cash-out refinance, including closing costs and fees, before deciding. Make sure these don't cancel out the savings from refinancing.
Understanding Cash-Out Loans
A cash-out loan is an umbrella term for what can be a variety of different loan options, including conventional, FHA, and VA loans. All these loans give you access to funds from the equity in your home.
- Conventional cash-out loans: Banks and other financial institutions typically offer these loans, which tend to be the most widely available type of cash-out loan. Still, there are certain eligibility requirements that may apply (including a minimum credit score and a down payment).
- FHA cash-out loans: FHA (Federal Housing Assistant) Loans are a fairly popular option among first-time homebuyers. The federal government backs these loans and typically offers more flexible terms than conventional cash-out loans. If private lenders are unwilling to offer you a loan, FHA loans may be a good way to access the equity in your home.
- VA cash-out loans: VA (Veterans Affairs) Loans may be suitable if you're an active veteran or service member. These loans come with unique benefits and protections designed to help veterans obtain financing at more favorable rates. (Learn more about the best personal loans for veterans next)
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Alternatives to a Cash-Out Refinance
Upon considering the risks and rewards of a cash-out refinance, you might decide it's not for you. The good news is that alternatives to a cash-out refinance might be right for you.
A home equity line of credit (HELOC) is one option. This allows you to borrow against the equity in your home, but with a much smaller loan amount and no closing costs or monthly payments. If you go this route, understanding the repayment process and rules associated with a HELOC is key.
Home equity loan
A home equity loan is another potential alternative. With this option, you borrow a set amount of money at one time and make regular payments on that loan until you pay it off. Much like a HELOC, specific terms come with a home equity loan you'll want to understand before pursuing it as an alternative to cash-out refinancing.
A personal loan is yet another option for borrowers who don't want to tap into their home's equity but still need funds for a considerable expense.
However, these loans can come with higher interest rates than other forms of financing, so be sure to research the terms and interest rates of any personal loan before you land on one.
If you need access to funds quickly, using a credit card as an alternative to cash-out refinancing may be tempting. However, this should only be considered a last resort due to high interest rates on credit cards. In addition, for this option to make sense financially, you would have to pay off the balance in full each month and ensure you don’t miss payments.
Refinance with a lower rate
If you're trying to save money on your mortgage, refinancing with a lower interest rate is another option. This could help you lower your monthly payments and put more money back in your pocket each month. But, again, you'll want to carefully research the terms and interest rates associated with any refinancing option you pursue.
(We talk more about mortgage interest rates and how they're determined here).
Finally, another potential alternative is selling assets. This could include cars, furniture, jewelry, or any other valuable possessions you own. This often isn’t an easy decision, but for quick-access to much needed funds, it can prove effective.
If you have a pressing financial need that cannot be met through other means, such as high-interest debt or significant home repairs, cash-out refinancing may be a viable option. Additionally, if you have a substantial amount of equity in your home and can obtain a lower interest rate than your current mortgage, cash-out refinancing could potentially save you money over the long term. Ultimately, the decision to pursue cash-out refinancing in a high interest rate environment should be based on your individual financial circumstances and goals. It's always a good idea to consult with a financial advisor or mortgage professional before making any significant financial decisions.