In a cash-out refinance, you take a loan out for the loan balance you already have plus a portion of the equity accumulated in your home. That amount beyond the loan balance can be used for a variety of reasons.
Homeowners may use the cash from a cash-out refinance to consolidate debt, get a lower interest rate on credit, pay for a child’s college expenses, or remodel the house. Let’s take a look at when this refinancing option makes sense, according to financial experts.
The Benefits of a Cash-Out Refinance
For many homeowners, their home is their biggest expense. This means saving even one percent of interest on your mortgage can mean saving hundreds or thousands of dollars every year. For example, a $300,000 mortgage with a 4 percent interest rate is $1,432 a month on a 30-year mortgage. The same mortgage at 3 percent drops to $1,265 a month.
But that’s if you refinanced the existing mortgage dollar for dollar. What happens if you want to use your refinance to tackle that $15,000 of credit card debt that charges 21 percent interest? By adding the credit card debt to the mortgage, the credit cards are paid and you now pay the interest rate of the mortgage – far less than the credit cards. It’s a way to pay off debt for a more reasonable cost.
Not everyone uses a cash-out refinance to pay off credit card bills though. Some use the equity in their home to fund their kids’ college education, wedding, or home renovations. Imagine having a home valued at $400,000 with a mortgage of $250,000. That’s $150,000 of equity sitting in your house. Often you can access up to 80 percent of the equity – or in this case, $120,000 to fund the big-ticket items in your life.
The Pros and Cons of a Cash-Out Refinance
Like any financial decision, it’s important to weigh the risks and benefits of a cash-out refinance. To that end, Rick Orford of The Financially Independent Millennial warns that it isn’t an end-all solution to bad spending habits.
“It doesn’t matter if you earn $50,000 a year, or $150,000 a year,” Orford says, “unless you spend less than you earn, you’ll never get ahead.”
|Reduce the cost of more expensive debt||Extends your mortgage for a new term|
|Often lowers your mortgage interest rate||Has closing costs|
|Affords the opportunity to pay for big-ticket items||Has lengthy underwriting requirements including a credit report and appraisal|
While it seems like a cash-out refinance would solve a lot of problems, if you don’t plan on living in your home for years to come, it could affect your ability to qualify for another mortgage. You’ll have less equity, have a hard pull on your credit, and will need to account for the cost of an appraisal and closing costs.
According to Tony Grech of Luxury Mortgage, “You don’t need perfect credit to get a cash-out refinance, but these types of loans are viewed as much riskier than a purchase or a refinance to simply lower the rate on your loan balance.”
It takes years to build up equity, and taking on more debt is not always a good idea.
How Much Can You Get In a Cash-Out Refinance?
In a cash-out refinance, you’re cashing out the equity in your home. How much equity you have will determine how much you can take out. An easy way to roughly calculate your home’s equity is to subtract your mortgage balance from your home’s current market value.
For example, say your home’s market value is $256,000 and you have a $158,000 mortgage balance. You’d have about $98,000 in equity.
In many loan circumstances, you can access up to 80 percent of the equity in the home. If we continue the example above, that means you could potentially take out $46,800 in your cash-out refinance.
Lenders set your borrowing limit at 80 percent of your equity to leave you with a cushion in case the house drops in market value. That way you won’t owe more than the value of the home.
It also gives the lender a cushion if you default on the property and they need to sell the home. The value will likely still have some equity, leaving them some room to negotiate with buyers.
There is one exception to the 80 percent rule on a cash-out refinance: if you have a VA loan, you will be able to access up to 100 percent of the equity in the home.
Exactly how much you can take out may be contingent on lender rules and your creditworthiness.
How Does a Cash-Out Refinance Work?
In order to get a cash-out refinance, you’ll have to qualify for it just like you did with your original mortgage. Lenders want to see at least a FICO credit score of 620, which is higher than a simple refinance score requirement of 580.
You’ll need to meet the debt-to-income (DTI) ratio of less than 50 percent. The DTI ratio is your monthly debt payments divided by your income. This includes your mortgage, car payments, and credit card payments.
Lastly, you’ll need at least 20 percent equity in your home. This means for every $100,000 your home is valued at, you have at least $20,000 in equity. From there, you’ll be able to pull out up to 80 percent of that equity (or 100 percent if you have a VA loan).
Cash-Out Refinance vs. HELOC (Home Equity Line of Credit)
Homeowners should review the difference between a cash-out refinance and a HELOC to make sure they are doing the best thing for their financial situation. Unlike a refinance, a HELOC uses your equity to fund a line of credit that you can access at will. It often has a variable interest rate that is locked for one to three years.
Generally speaking, you tend to pay lower interest rates on a cash-out refinance than a HELOC. But remember that the loan is fixed for the life of your mortgage whereas a HELOC can be paid down quickly and reused for other purposes. Consider the closing costs along with the interest rate when comparing a refinance with a HELOC. You’ll want to run the numbers to see where you save the most.
But if you’re doing a renovation of your home, a cash-out refinance can be a powerful financial tool. You’ll get lower interest rates and you’ll invest into the home which will only increase its market value.
According to Matt Rostosky of Good Neighbor Solutions, LLC, “Big-ticket home renovations give you the most out of your cash-out refinance money.”
When to Not Take a Cash-Out Refinance
In a cash-out refinance, you assume more debt and lock it in for a 15 to 30-year mortgage, so make sure it makes sense for your financial situation. In most cases, you don’t want to do the refinance if your interest rate will be the same or higher with the refinance. Your whole mortgage will get charged more interest, and that’s typically not a good move.
It’s also not a good idea to do the cash-out refinance if you can’t consolidate all your high-interest credit debt. If you did the refinance anyway, you’d be paying more for your mortgage and still fighting high-interest rates on credit cards.
Remember to consider the closing costs of the new loan, too. These costs could be as much as 5 percent of the mortgage amount – that could easily be $10,000 on a $200,000 loan. Make sure that your potential savings will be worth the cost of the loan. Your lender should provide you with a breakeven point that shows you how long into the new loan you will break even with the new costs. If it’s more than two to three years, a cash-out refinance might not be worth it.
Be Strategic with Cash-Out Refinances
A cash-out refinance is a powerful way to tap the equity of your home to help you meet other financial goals. Whether you want to consolidate debt, remodel your home, or pay for college, the cash-out refinance gives you access to capital that’s otherwise tied up in your house. Remember to always consider the costs before doing a refinance so you don’t pay more than you should.