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If you have built up some equity in your home, the equity can be a source of money to make needed purchases, pay for home improvements, fund your child’s education, and other purposes. One way that you can gain access to the equity in your home is to complete a cash-out refinance of your mortgage. A cash-out refinance can allow you to gain access to your equity so that you can use the money for whatever you need. You need to understand cash-out refinances and how they work so that you can determine whether it might be a good option for you.
What is a cash out refinance?
A cash-out refinance is a new mortgage that takes the place of your current mortgage. The cash-out refinance mortgage will be for a greater amount than what you owe on your current mortgage. You can receive the difference between the amounts of the new and old mortgages and use the money for whatever you want. Like other mortgages, a cash-out refinance loan will have closing costs. It allows you to take advantage of the equity that you have in your home to accomplish your financial goals.
Cash out refinancing vs. Rate and term refinancing
A rate-and-term refinance of a mortgage is a refinance option that allows you to adjust the terms of your mortgage or to obtain a lower rate of interest. Since today’s mortgage rates are low, this type of mortgage refinancing can make sense if you purchased your home when the interest rates were higher. It can also make sense for you to choose this type of mortgage refinancing when your circumstances have changed, allowing you to switch from a 30-year mortgage to a 15-year mortgage. Refinancing your mortgage to a shorter-term can help you to save substantial sums on interest payments even though your monthly payments will be higher than they are for your 30-year mortgage.
Cash-out refinancing works differently. This type of mortgage loan allows borrowers to turn the equity that they have in their homes into cash. In a cash out refinance, the borrower takes out a new mortgage that is larger than what he or she owes on his or her current mortgage. The old mortgage is paid off with the new mortgage loan, and the borrower is given the difference in a lump sum payment. This type of loan is only available to borrowers who have built equity in their homes above what they owe on their mortgages. The additional monetary amount of the refinanced mortgage is paid to the borrower at the loan’s closing.
In general, cash-out refinance mortgages typically have higher interest rates and costs than rate-and-term refinance loans. Higher fees and interest may be charged because the lenders might be worried that borrowers who take out a substantial amount of equity might fail to keep up with the payments on their new mortgages. However, if you have a high credit score, a low debt-to-income ratio, and a low loan-to-value ratio, you can secure a better deal on your cash-out refinance mortgage. The lender will place limitations on the amount of equity that you can withdraw to make certain that you keep a cushion of equity between your loan amount and the value of your home.
Example of cash-out refinancing
Reading an example of cash-out refinancing can help you to understand how it works. Imagine that you owe $80,000 on your mortgage, and your home is worth $300,000. Lenders generally require borrowers to keep a minimum of 20% equity in their homes following a cash-out refinance. This means that your available equity for your cash-out refinance would be capped at 80%. Using the example above, start by calculating the value of 20% equity by multiplying 0.2 x $300,000 to get $60,000. Then, subtract $80,000 from $300,000 to get the equity balance in your home of $220,000. From that amount, subtract $60,000. This means that the equity in your home that might be available to you in a cash-out refinance is $160,000 in cash.
According to data from Freddie Mac for the second quarter of 2019, homeowners cashed out an estimated $17.5 billion of the equity in their homes. Out of all of the mortgages that were refinanced during the second quarter, 61% were for higher amounts than the original mortgages, indicating that they were cash-out refinance loans.
Cash-out refinancing options limits
Lenders calculate a home’s loan-to-value ratio to determine the maximum amount for a cash-out refinance. The lenders compare the homes’ current market values with the outstanding balances that the borrowers owe on their existing mortgages.
Using the previous example for a home that has a market value of $300,000 with an outstanding loan balance of $80,000, assume that the lender has established a maximum loan-to-value ratio of 80%. As described above, the maximum amount that you could get for a cash-out refinance is $160,000. The lender’s 80% loan-to-value ratio would mean that the maximum amount of your new loan would equal $240,000. After your old mortgage is paid off by the loan proceeds, it would leave you with the $160,000 that remains.
Reasons why borrowers use cash-out refinance loans
Cash-out refinance loans offer several advantages over other types of loans when you need access to a large amount of money. Some of the advantages of getting a cash-out refinance loan include the following:
- Potential to get a lower interest rate
- Ability to make home improvements that add to your home’s value
- Ability to consolidate and pay off your debt
- Help to pay your child’s tuition
While cash-out refinances often have higher interest rates than rate-and-return refinance mortgages, you may be able to find a cash-out refinance loan that has a lower interest rate than the rate that you currently pay. Getting a lower interest rate is the primary reason most people choose to refinance their mortgages. When you are wanting to complete a cash-out refinance, it makes sense to look for a lower interest rate to lower your interest costs for the larger loan.
A good way to use a cash-out refinance mortgage is to use the money to make home improvements that add value to your home. When you use the proceeds of a cash-out refinance to complete home renovations, you can deduct the interest on your income taxes. It can also be less expensive to use a cash-out refinance to pay for home improvements than your credit cards, a personal loan, or a home equity loan.
Consolidating and paying off debts that have higher interest rates can be a good use of the funds from a cash-out refinance. However, you will want to take into account the closing costs and points that you will pay to make certain that you will be paying less. You will also want to make sure that you will be able to afford the new payments and that you do not run up your credit cards and other debts again while paying your mortgage.
If the student loan interest rates are higher than the rates that you would have to pay with a cash-out refinance, it can make sense to refinance your home and to pay your child’s college tuition with the proceeds. You will want to calculate the amount that you will have to pay for a student loan and a cash-out refinance to check which type of loan makes better sense.
When a cash-out refinance mortgage should be avoided
There are some situations in which you should avoid getting a cash-out refinance. If these risks apply to you, it might be a better choice to choose an alternative to a cash-out refinance.
If a cash-out refinance mortgage carries a higher interest rate than your current mortgage, you should avoid it and look for a different mortgage or an alternative. When you refinance, you should look to get a lower interest rate and improve your finances. If your interest rate will increase significantly, you might want to avoid a cash-out refinance.
Some lenders allow people to cash out up to 90% of the equity in their homes. However, doing so might mean that you will have to pay private mortgage insurance again. Having to pay private mortgage insurance can increase your borrowing costs as compared to other financing sources.
When you plan to use funds from a cash-out refinance to repay your other debts, make certain that you are not dragging out the repayment of your debts for several decades when it could have been repaid sooner and at a lower cost without a cash-out refinance. When you take out a cash-out refinance, you will be spreading the payments over 30 years. This means that using a cash-out refinance to pay off credit card debt might not provide you with as many savings as you might think. The other danger is that some people do not refrain from using their credit cards and running up their debts again, which could leave you paying your new credit card debt along with your higher mortgage debt.
When you take a cash-out refinance, you will have a higher risk of losing your home. If you find that you cannot repay the loan, you could lose your home to foreclosure. To prevent this from happening, only take out the money that you need and use it for a purpose that will help to improve your finances instead of making your situation worse.
Finally, a cash-out refinance is not a good idea if you want to use it to take expensive vacations or to make purchases because this indicates that you do not have good control over your spending. You should not treat your home like a piggy bank. If you are having trouble controlling your spending or your debt, you might want to talk to a nonprofit credit counseling agency instead of taking out a cash-out refinance loan.
How much money can you get from refinancing your home and taking a cash-out?
While many lenders allow homeowners to borrow 80% of their homes’ values, the maximum will vary and depend on the lender, the type of mortgage, and your credit score. Some lenders offer mortgages that are insured by the Federal Housing Administration. These lenders may offer cash-out refinance options that allow borrowers to borrow up to 85% of their homes’ values. If you get a cash-out refinance loan that is guaranteed by the Department of Veteran Affairs, you can borrow up to 100% of the equity in your home.
What fees will you have to pay for cash-out refinancing?
When you complete a cash-out refinance of your home, you should expect to be charged from 3% to 6% of your new loan amount in closing costs. These costs will include an appraisal fee and a lender origination fee. You should shop around to make certain that you are getting the best terms and rates.
The lender might allow you to roll your closing costs into your mortgage, but you will likely be charged a higher interest rate for doing that. Refinancing your mortgage at a higher rate of interest might mean that you will pay more in interest than you would be when you pay the closing costs upfront. It is a good idea to calculate it both ways to determine which is better for you.
Alternatives to cash-out refinances
Some alternatives to cash-out refinances include the following:
- Reverse mortgage
- Home equity loan
- Home equity line of credit
- Personal loan
A reverse mortgage is available to homeowners who are ages 62 and older who own their homes outright or have built up substantial equity. This type of mortgage allows eligible borrowers to withdraw the equity from their homes without having to repay the loan as long as they continue living in their homes, paying their homeowners’ insurance premiums, paying their property taxes, and keeping their homes maintained. When the homeowner dies or moves out of the home, it can then be sold to repay the lender.
A second mortgage, a home equity loan provides you with a lump sum payment with a fixed interest rate. Having a fixed interest rate can help you to budget your additional payment in.
A home equity line of credit is a revolving line of credit that allows you to borrow from the equity of your home when you need money. It can be helpful if you will need money over several years. HELOCs have variable interest rates. If you get a HELOC, you should only take out money that you actually need.
Checklist before you take out a cash-out refinance mortgage
Before you take out a cash-out refinance mortgage on your home, you should do the following things:
- Carefully calculate the numbers to make certain that a cash-out refinance is the right option for you.
- Think about the reason why you need the money.
- Compare the cash-out refinance loan with alternatives.
- Make certain that you will be able to afford your new payments.
- Look for a loan with a lower interest rate than what you are currently paying.
- Comparison shop to find the best terms and rates.
A cash-out refinance can offer a great way for you to access a large sum of money to meet your financial needs. This type of financing can allow you to make home improvements, pay for your child’s college tuition, consolidate your high-interest debts, or to secure a lower rate of interest than what you are currently paying. When you use a cash-out refinance loan correctly, it can help to improve your finances and to meet your financial goals. Now that you understand how cash-out refinances work, do you think that it is the right option for you?