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As a homeowner, you’ve probably heard a lot about refinancing. An individual will often refinance their mortgage to take advantage of lower interest rates or pull out equity from their home. However, a less common but still viable option is the cash-out refinance. Keep reading to find out if a cash-out refinance is a good idea and if it’s right for you.
What is a cash-out refinance loan?
A cash-out refinance is a very different form of refinancing. You’re still going through the process of switching out your current mortgage for a new one, but you’re actually taking out a mortgage for more than your current outstanding balance. You subtract the cost of your leftover mortgage and get to keep the difference as cash.
To explain this more clearly, we’ll walk you through an example. Let’s say you had an outstanding mortgage balance of $100,000 on a home that’s worth $350,000. If you took a cash-out refinance loan, you’d refinance the $100,000 balance, plus you could take out an additional amount to keep as cash.
So if, say, you had plans to renovate and needed $30,000, you could refinance a new mortgage of $130,000—$100,000 for the mortgage and $30,000 for your renos.
It’s important to note that you won’t just be able to take out however much you want. You’ll need to prove you can afford the new monthly payments—in this case, a monthly payment for a $130,000 mortgage. Most lenders will let you take out up to 80 to 90 percent of your home’s value.
Usually, a cash-out refinance takes between 30 and 45 days to finalize, so make sure to factor that in when you’re considering your options.
Who is eligible for a cash-out refinance?
Just like with your initial mortgage, you’ll have to qualify and be approved for a cash-out refinance loan. Typically, lenders want to see:
Additionally, a cash-out refinance loan is typically only an option if you have at least 20 percent equity in your home.
When is it a good idea to do a cash-out refinance?
There are several reasons why a cash-out refinance may be a smart choice.
If you want a lower interest rate (and cash)
You’re likely looking into refinancing because you believe you can secure a lower interest rate on your mortgage. A lower interest rate on your mortgage can save you thousands of dollars over the life of the loan. However, if you don’t need the cash, you might as well just do a regular refinance. A normal refinance can be easier to qualify for.
If you want to help pay for college tuition
One of the most popular reasons people select a cash-out refinance loan is to help pay for higher education for themselves or their loved ones. If you don’t qualify for a federal student loan and don’t want to go the route of private student loans with enormous interest rates, this option may be the most affordable.
If you want to pay off credit cards
Some people use the cash from a cash-out refinance to deal with debt. This includes:
- A credit score of 620 or higher
- A good loan-to-value (LTV) ratio—your LTV ratio is the ratio of your loan size versus what your home is worth
- A balanced debt-to-income ratio that shows you can afford the mortgage payments— this usually means a debt-to-income ratio of less than 50 percent
However, we must caution that this is a risky approach. For this to be worth it, you have to ensure you don’t rack up debt again. If you go the cash-out refinance route to pay off high-interest credit card debt and then acquire debt all over again, it’s simply not worth it. Additionally, you’ve risked your house for no benefit.
If you want to make improvements to your home
The cash-out refinance approach is a great way to finance home improvements. The average cost to renovate or remodel a home can range between around $18,000 and $76,000. Usually, this is more cash than most people have on hand.
A home renovation is an excellent choice because it can improve your home’s value. So, you’re essentially putting the money back into your home and rebuilding the equity you took out.
When should you reconsider doing a cash-out refinance?
A cash-out refinance is simply not the right choice for everyone. There are some clear instances when this route is detrimental.
If you have to pay PMI again
Mortgage lenders charge private mortgage insurance (PMI) whenever an individual doesn’t have a 20 percent down payment. When you go the route of a cash-out refinance loan, some lenders will allow you to withdraw more than 80 percent of your home’s value. Unfortunately, this will reestablish PMI as you now have less than 20 percent of your house paid off.
PMI is an expensive additional cost. It’s also a cost that’s not adding to your equity. Private mortgage insurance ranges from 0.5 to 1.5 percent of your loan amount per year.
Let’s say you have a property valued at $350,000 and you’ve taken out 90 percent in a cash-out refinance. With an average PMI of one percent, your PMI costs you an extra $263 per month—$19,282 over a 30-year loan. For most people, the reintroduction of PMI detracts from other cost savings.
If the terms of your new mortgage are unfavorable
Any time you refinance, you incur additional costs. You’ll typically pay between three and five percent of your new loan amount in closing costs, which can include fees such as:
- An appraisal fee
- A lender origination fee
- Legal fees
It’s essential to consider these costs, along with your new interest rate, to truly understand if you’re coming out with a better deal. For example, a minimal reduction in your interest rate sometimes doesn’t make up for the closing costs.
Additionally, you might also want to consider the impact of prolonging your debt. Sometimes refinancing means signing a longer loan. You may have been 10 years into a 30-year loan, and when you refinance, you sign up for another 30 years. This is an additional 10 years that you’re in debt. It’s also 10 more years of paying interest.
If you can’t make the payments
You risk losing your home with any mortgage, so if you’re refinancing to consolidate debt, be extra careful. Unlike with credit cards, a cash-out refinance is collateral-backed. Your house is on the line and at risk if you stop making payments.
What are some alternatives to a cash-out refinance?
Some alternatives to a cash-out refinance include HELOCs, home equity loans, personal loans and reverse mortgages.
Home equity line of credit (HELOC)
A home equity line of credit uses your home as collateral on revolving credit. You can tap into this credit line any time because it’s always available to you. Note, though, that a HELOC has a variable interest rate that changes with the prime rate, so it’s important to understand the current interest rate before taking out money.
This option is ideal for people who’ll require access to money for a longer time, such as if you need several years to complete home renovations.
Home equity loan
A home equity loan is a one-time loan against your house that counts as a second mortgage. It gives you a lump-sum payment with a fixed interest rate, so you know exactly how much you have to pay back each month.
Personal loan
You can get a personal loan from virtually any private lender, financial institution or credit union. These loans are typically approved based on your credit score, credit history and income level. A personal loan can vary greatly in terms, interest rates and repayment plan options.
Reverse mortgage
A reverse mortgage allows individuals to tap into their home equity without having to sell the property. Generally, you don’t have to repay this money as long as you live in the home. As a bonus, this money is usually tax-free.
Is a cash-out refinance right for you?
A cash-out refinance loan is the best option for some people. However, you need to dedicate significant time and effort to determine if it’s the correct choice for you. It’s important to consider costs versus savings, long-term impacts and even your attitude toward finances.
Typically, only individuals with good credit can qualify for a cash-out refinance, or at least one that’s worth it. This is reflective of many personal finance options—the better your credit, the better your options. If you want to see lower interest rates and more credit opportunities, you need to focus on building up a healthy credit score.
A low credit score doesn’t have to be a death sentence. With credit repair services, individuals can see their credit scores steadily climb. And once that score is high enough, new opportunities will often present themselves.
