How does a cash-out refinance work?
A cash-out refinance works by converting a portion of the equity in your home into cash. As with any type of home refinancing, a cash-out refinance loan will replace your existing mortgage with an entirely new one.
However, unlike the outcome of a simple rate and term refinance, your new mortgage will be more than the remaining balance on your original mortgage. You’ll receive the difference as a lump-sum cash payment, which you can use for any purpose, such as home repairs, debt consolidation, or covering unexpected expenses. There are also options available for those with FHA loans and VA loans.
The amount you can receive in a cash-out refinance loan itself is based on your home equity, which refers to the difference between your home’s current value and how much remains on your mortgage. In other words, equity reflects the amount you’ve invested in your property. If your home is currently worth $415,000, for instance, and your remaining mortgage balance is $120,000, you have $292,000 worth of equity in your home.
Keep in mind that most lenders expect you to keep at least 20% of your home’s equity in your home, meaning you can only receive a loan for 80% of your home’s equity. In the above example, you could receive a loan for $233,600 and use $120,000 to cover your remaining mortgage balance, giving you $113,600 to use however you want.
Just remember that in a cash-out refinance, all the usual loan terms apply, and your house itself will serve as collateral for the loan. If you fail to repay the loan, you could lose your home.
Pros and cons
Determining whether a cash-out refinance loan is right for you means carefully weighing the pros and cons of the financing option.
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Pros
A cash-out refinance offers some great benefits to homeowners, including things like:
1. Lowering your interest rate
Through home refinancing, you replace your current mortgage with a whole new one. If rates have dropped (or if you have a higher credit score) since you first purchased your home, you could receive better loan terms and interest rates.2. Reducing your cost to borrow
Since you’re relying on the equity in your home, the cost to borrow could be lower than other loan programs. You’ll also be paying off your loan with your monthly mortgage payments, which eliminates the confusion of multiple bills.3. Improving your credit
Paying off credit card debt with your loan can improve your credit score, as does making consistent on-time payments.4. Taking advantage of tax deductions
Perhaps you plan to use your cash-out refinance loan to make home improvements. If so, you may be able to deduct the interest payments of the cash-out portion of the loan from your income taxes. Just keep in mind that the improvements must add to the value of your home for them to apply. -
Cons
Despite the clear benefits, homeowners should still exercise caution before entering into a cash-out refinance loan for the following reasons:
1. Your interest rate may go up
Current interest rates may not necessarily be competitive with your original loan. A cash-out refinance, therefore, can lock you into a higher interest rate, which means you’ll pay more over the lifetime of your loan.2. You’ll make payment for decades
A cash-out refinance loan can add years (even decades) to your mortgage. As such, you’ll effectively be “restarting” your mortgage, so you must consider how loan terms will affect your budget.3. A greater risk of losing your home
In a cash-out refinance loan, your home itself serves as collateral. Therefore, if you’re unable to pay your loan balance, your lender can foreclose on your home.
Cash-out refinance FAQs
A cash-out refinance loan may sound simple enough, but below are some questions homeowners often ask about the process and the benefits of a refinancing loan:
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Typically, a cash-out refinance loan will be a good option when at least one of the following conditions are met:
- You need a sizeable lump sum of cash
- You have significant equity built in your home
- Your financial situation has improved since your original loan
- Interest rates are down
Still, it’s important to compare rates and terms from different lenders to determine whether a cash-out refinance is the best option. If you’re going to face a higher interest rate, you may want to consider alternative options.
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Most lenders will allow you to borrow up to 80% of the equity in your home. But remember that a portion of the loan will go to the balance of your existing mortgage. As such, you can receive 80% of your current equity minus the amount remaining on your current mortgage.
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Yes, and that’s because lenders want to ensure that they’re only providing a loan for what the home is actually worth. You’ll have to get a home appraisal from a certified, state-licensed home appraiser. They will visit your property to determine its value, then submit a report based on their findings.
How to get a cash-out refinance
Like any loan, you’ll experience better results if you prepare for the lending process. Here are the steps you’ll need to take to get a cash-out refinance loan:
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1
Calculate your home equity
First, determine the total equity in your home by subtracting the balance of your current mortgage loan from the current market value of your home.
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2
Determine your loan amount
Lenders will typically restrict you to a loan of 80% of your home’s equity. Therefore, if you have $250,000 of home value, just as an example, your maximum loan will be $200,000. And if you still owe $150,000 on your mortgage, the maximum cash-out portion of your loan will be $50,000.
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3
Assess your finances
When refinancing your home, you’ll go through a similar process as when you received your first mortgage. As such, your final interest rates and loan terms will depend on factors such as:
- Your current income
- Your credit score
- Your debt-to-income ratio
Ideally, these factors will have improved since your first mortgage, and if so, they can help you secure better rates and terms.
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4
Complete an application
Once you’re ready, complete an application. You’ll have to go through an underwriting program before you receive your loan, which can take as much as 30 to 45 days, depending on how quickly your home can be appraised and the loan can be processed.
Loan alternatives
A cash-out refinance loan isn’t the only way to convert the equity in your home into spendable cash, nor is it the only way to get extra money for home improvements or other personal expenses.
Some alternatives to a cash-out refinance include the following:
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A home equity loan (also known as a second mortgage) will let you borrow an additional lump sum of money. Usually, you can borrow roughly 80% of your home’s value minus the remainder of your mortgage.
However, your interest rate won’t change, as you’re simply adding a secondary loan to your monthly payment. With that in mind, when it comes to refinance vs. home equity loans, many homeowners prefer the former.
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A home equity line of credit (HELOC) also lets you convert your home equity into cash. But instead of a lump sum of cash, you can tap into your equity on an as-needed basis. Much like a credit card, you can borrow up to your credit limit. And you’ll only pay interest on what you borrow.
A HELOC is, therefore, an ideal choice if you’re not sure exactly how much money you’ll need. While lenders typically want you to retain 20% equity, HELOCs will still give you access to up to 80% of your value. Still, just as before, your home will serve as collateral, and it will end up in jeopardy if you can’t repay your loan.
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Personal loans also allow you to access large cash sums for flexible purposes. While the interest rates on personal loans can be a bit higher than home equity loans, you won’t have to use your home as collateral. That can add a safety net to your borrowing strategy, as there’s no danger of losing your home.
Final thoughts
A cash-out refinance can be an excellent way to fund major purchases or home improvements. However, it’s vital that you consider how your interest rates and monthly payments might change as a result of a refinance.
If you still have questions, talk it over with a real estate professional. They may be able to provide you with additional guidance unique to your financial situation or steer you toward an alternative that better suits your needs.
