Cash-out refinancing is a financial tool that allows homeowners to tap into the equity of their home. This gives them access to cash that can be used for a variety of purposes.
Explore what cash-out refinancing is, how it works, the pros and cons, and when it might make sense for you.
Also, learn about how to secure the best rates, as well as alternatives to cash-out refinancing.
What Is a Cash-Out Refinance?
A cash-out refinance is a type of mortgage refinancing where you replace your current home loan with a new, larger loan.
With this type of refinance, the difference between the old loan amount and the new loan amount is paid out to you in cash.
The option is popular for homeowners who have built up significant equity in their home and want to access it for various financial needs, such as debt consolidation, home improvements, or large purchases.
A cash-out refinance can be more affordable than taking out personal loans or using high-interest credit cards, as mortgage interest rates tend to be lower than the rates attached to those other forms of borrowing.
How Cash-Out Refinancing Works
Here is a step-by-step rundown of the process that results in a cash-out refinance:
Determine how much cash you need: Before applying, it’s important to know how much money you want to take out. For example, if you’re planning to renovate your home, get estimates from contractors to ensure you’re borrowing the right amount.
Check eligibility: Here are some factors that determine your eligibility for a cash-out refinance:
Credit score: Lenders usually require a minimum credit score of 620 for conventional loans. However, FHA loans and VA loans may allow for scores as low as 580.
Equity: You need to have sufficient equity in your home, as lenders typically only allow you to borrow up to 80% of the home’s value (loan-to-value ratio, or LTV).
Debt-to-income ratio (DTI): Most lenders prefer a DTI ratio of 43% or lower, although this can vary by loan type. For instance, FHA and VA loans may allow a DTI ratio as high as 50%.
Apply: After confirming that you meet the eligibility requirements, choose a lender and apply. You’ll need to provide documentation, including proof of income, credit history, and information about the property.
Wait for approval and closing: Once your application is approved, the lender will issue a new mortgage, paying off your old one. The remaining balance is given to you in cash. The entire process usually takes 30 to 60 days.
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Pros and Cons of Cash-Out Refinancing
Here are the potential positive and negative aspects of a cash-out refinance.
Pros
Access to cash: The biggest advantage of cash-out refinancing is the ability to convert your home’s equity into liquid cash. This money can be used for a variety of purposes, from paying for home improvements to funding a child’s education or consolidating debt.
Lower interest rates: Mortgage rates are generally lower than rates on personal loans or credit cards. By refinancing and using the money to pay other debts, you can lower your borrowing costs overall, potentially saving thousands of dollars in interest payments
Cons
Higher monthly payments: Since you’re increasing the loan amount, your monthly mortgage payments will also grow in size unless you extend the loan term. This could strain your budget.
Closing costs: Just as with any mortgage, a cash-out refinancing comes with closing costs. This typically ranges from 2% to 5% of the loan amount. Such fees can add up and reduce the amount of cash you receive.
Risk of foreclosure: By taking out a larger mortgage, you are putting your home at greater risk. If you’re unable to keep up with the higher payments, you could face foreclosure.
When Does Cash-Out Refinancing Make Sense?
Cash-out refinancing isn’t for everyone, but it can make sense if you have any of the following goals:
Lowering your interest rate: If mortgage rates have dropped since you first took out your home loan, cash-out refinancing can lower your rate, saving you money in the long term. That can be true even if the loan amount is larger.
Consolidating high-interest debt: If you have credit card debt with high interest rates, a cash-out refinance can help you consolidate this debt into one lower-interest mortgage payment. This reduces your monthly interest expense and simplifies your payments.
Financing home improvements: Using a cash-out refinance to pay for renovations can increase the value of your home, which might give you a better return on investment over time.
Avoiding risky alternatives: A cash-out refinance is often a safer option than taking out a second mortgage or personal loan with higher interest rates.
When It May Not Be Worth It
If current mortgage rates are higher than your original rate, you could end up paying more in interest over time.
If your financial situation is unstable, increasing your monthly payments could be risky.
Alternatives to Cash-Out Refinancing
There are several alternatives to a cash-out refinance. They include:
Home equity loan (HELOAN): A home equity loan allows you to borrow against your home’s equity without replacing your current mortgage. This results in two separate payments — one for your original mortgage and one for the home equity loan.
Home equity line of credit (HELOC): Rather than giving you a lump sum, a HELOC provides a line of credit that you can draw on as needed. It functions much like a credit card, and you only pay interest on the amount you borrow.
Personal loan: For smaller cash needs, personal loans may be a faster and less risky option. However, interest rates on personal loans are usually higher than mortgage rates.
How to Get the Best Cash-Out Refinancing Rates
Some ways to cut the cost of a cash-out refinance include:
Borrow less: Lowering your LTV ratio by borrowing less money can result in a lower interest rate. If possible, pay down your current mortgage balance or increase your home’s value through improvements.
Shop around: Comparing offers from multiple lenders is essential to securing the best deal. Different lenders may offer different rates and terms, so it’s important to gather several quotes before making a decision.
Time the market: Keep an eye on mortgage interest rates and try to refinance when rates are low. Timing can make a significant difference in the total cost of your loan over time.
Is Cash-Out Refinancing Right for You?
Cash-out refinancing can be an excellent way to access your home’s equity and use it for important financial goals from debt consolidation to home improvement.
However, a cash-out refinance is not without its risks, and you should carefully consider whether taking on a larger mortgage is the right decision for your financial situation.
By weighing the pros and cons, understanding how cash-out refinancing works, and shopping for the best rates, you can make a smart, informed choice.
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