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Exploring financial strategies in homeownership often leads to considering a cash-out refinance, among other options. This article sheds light on its potential advantages and pitfalls, helping you make well-informed decisions tailored to your financial objectives.
What Is a Cash-Out Refinance?
In real estate, refinancing is the process of replacing an existing mortgage with a brand-new one with more favorable terms.
By refinancing, borrowers can decrease monthly mortgage payments, negotiate lower interest rates, renegotiate the term, remove other borrowers from the loan agreement, and/or access cash through home equity that has been built over time. This last option is called a cash-out refinance.
With this option, the new mortgage is for a larger amount than the existing loan amount. This allows the owner to convert home equity into cash. Typically, this cash is used for home repairs, updating the property, or consolidating debt.
How Does a Cash-Out Refinance Work?
There are two common types of mortgage refinance:
- Rate-and-term refinance, which doesn’t involve any money changing hands (besides closing costs)
- Cash-out refinancing, which turns some of the equity in the home into cash. Owners emerge from the closing with a new loan and a check for cash.
Unlike a rate-and-term refinance, where the primary goal is to attain a lower interest rate or a different term length without exchanging any cash, cash-out refinancing provides the homeowner with actual money, the amount of which is calculated based on the equity accumulated in the home.
In simple terms, this process involves replacing the existing mortgage with a new, larger one, with the difference handed over to the homeowner in cash.
Advantages of a Cash-Out Refinance
There are many advantages associated with a cash-out refinance. Understanding these will help you decide if it’s the best strategy for your situation.
Access to liquid funds
A cash-out refinance transforms your home’s equity into accessible funds, providing immediate liquidity. This is particularly beneficial for addressing urgent financial needs or seizing investment opportunities.
Consolidating higher-interest debt
Through a cash-out refinance, you can consolidate multiple higher-interest debts into a single loan with a potentially lower interest rate. This can lead to lower monthly payments and a more manageable financial ledger.
Home improvement and renovation financing
Homeowners often use the cash from a refinance to fund home improvements and renovations, which, in turn, can increase the property’s value.
Certain tax benefits may accompany a cash-out refinance, as mortgage interest can often be tax deductible. This aspect can provide an additional financial incentive for homeowners considering this refinancing option.
Risks of a Cash-Out Refinance
Despite the many benefits of a cash-out refinance, there are some potential risks. Knowing about these will help protect you against making a poor decision.
Engaging in a cash-out refinance increases the loan amount against your home, which could lead to overleveraging. This is a precarious position, as it might result in owing more than the home is worth, especially in a declining market, thereby increasing financial vulnerability.
Higher interest costs
A cash-out refinance may come with higher interest costs over the life of the loan, particularly if the new loan has a higher interest rate or longer term than the original mortgage. This could lead to paying significantly more in interest over time, offsetting the initial financial benefits.
Initiating a cash-out refinance involves closing costs, which can be substantial. These upfront costs, which cover things like appraisals, attorney fees, and lender charges, could erode the financial benefits gained from the cash-out amount.
How Much Money Can You Take Out With a Cash-Out Refinance?
The cash-out amount in a mortgage refinance is typically between 75% and 85% of the home’s value, depending on several factors. Lenders assess the difference between the current mortgage balance and the home’s market value, along with the borrower’s income and credit score. Many lenders also have set limits on the equity you can borrow.
The purpose of refinancing can impact the cash amount you receive. For instance, refinancing to pay off consumer debt may lower your debt ratio, potentially qualifying you for more cash. Similarly, if refinancing leads to home improvements and an increased property value, lenders might allow a larger cash-out.
Factor No. 1: Home equity
Home equity is the difference between the home’s value and the mortgage balance. If you have a home valued at $250,000 and a mortgage with $100,000 remaining, the equity is $150,000.
The amount of equity limits the amount of cash that can be taken out. Cash cannot be more than a property’s value and is generally limited to upwards of 85% of the property value. For example, a home worth $200,000 with a mortgage balance of $75,000 means equity is $125,000.
Factor No. 2: Mortgage qualification
Your income and debts play a role in determining the maximum mortgage amount. If a credit score is below a lender’s minimum level required for the maximum loan percentage, the lender often reduces loan-to-value limits.
For example, a mortgage program that permits an 85% loan-to-value maximum may only lend 70% or 75% because of a lower-than-optimum credit score. This will effectively reduce the amount of cash you can take out.
Factor No. 3: Program limitations
Most mortgage loan programs limit the loan-to-value maximum. For example, let’s say your home is worth $500,000, and you have $350,000 remaining on your mortgage balance. Your lender allows a loan-to-value maximum of 85%. The most cash you can take out is $75,000. That is determined by multiplying the loan-to-value percentage by the home value, and then subtracting the mortgage balance to learn the potential cash-out amount.
Considerations Before a Cash-Out Refinance
Here are some additional considerations before you make a final decision in favor of a cash-out refinance.
- Stable income: Lenders seek assurance that borrowers have reliable income to meet the new mortgage payments.
- Good credit score: A good credit score is often required to get favorable terms.
- Home equity: Significant home equity is crucial, as it determines the amount you can cash out.
- Debt-to-income ratio: A lower debt-to-income ratio is preferable to ensure you can handle the additional debt.
The loan-to-value (LTV) ratio is a critical factor, as it measures the relationship between the loan amount and the home’s value. A lower LTV often leads to better loan terms, ensuring lenders that there’s sufficient equity in the property.
Impact on credit score
A cash-out refinance will prompt a hard inquiry on your credit report, which may temporarily lower your credit score. Additionally, a new, larger loan can alter your credit profile, potentially affecting your score in the long term.
Closing costs in a cash-out refinance are typically between 2% and 5% of the loan amount. These upfront costs include appraisal fees, attorney fees, and lender charges, which may offset some of the financial benefits from the cash-out.
Interest rate and repayment terms
The interest rate and repayment terms are critical elements, as they impact the cost of the loan over time. A lower interest rate or shorter repayment term can save money in the long term, whereas a higher interest rate or extended term can increase the cost significantly.
How to Get Started With a Cash Out Refinance
Once you’re 100% sure that a cash-out refinance is the right path forward, it’s time to take action. Here are the three basic steps for getting started.
Find a lender
Selecting a reputable lender is the first step, and it’s beneficial to shop around for competitive rates and favorable terms. Engage with multiple lenders, compare their offerings, and choose one that aligns with your financial circumstances and goals.
Prepare required documents
Gathering necessary documents is crucial for a smooth, efficient application process. Typically, lenders will require proof of income, credit history, home appraisal, and other financial documentation to assess your eligibility and the loan terms they can offer.
Complete the application process
Once your documents are in order, fill out the application form provided by your selected lender. The lender will then review your application, perform necessary checks, and if approved, will guide you through the closing process.
The Closing Process of a Cash-Out Refinance
Closing on a cash-out refinance is not as complex as a new home purchase mortgage, but there are a couple of key aspects of the process.
Appraisal and underwriting
An appraisal is conducted to determine the current market value of your home, which, in turn, influences the amount you can cash out. The underwriting stage follows, where the lender evaluates your financial stability and the risk involved in offering you the new loan.
Signing documents and receiving funds
Once approved, you’ll move to sign the necessary documents that outline the terms of your new mortgage. Following a successful closing, the funds from your cash-out refinance are disbursed, either through a check or direct deposit into your account, completing the process.
Alternatives to a Cash-Out Refinance
Despite the many benefits of a cash-out refinance, you should compare the pros and cons to the following alternatives.
Home equity loans
Unlike a cash-out refinance, where you replace your existing mortgage with a larger one, a home equity loan allows you to take out a second loan against your home’s equity while keeping your original mortgage intact.
The primary advantage is that you can keep your current mortgage rate if it’s favorable, while accessing the needed funds.
A home equity line of credit (HELOC) differs from a cash-out refinance, as it provides a revolving credit line instead of a lump sum, allowing you to draw funds up to a certain limit as needed, similar to a credit card.
The primary advantage of a HELOC is the flexibility it offers in accessing funds, which can be particularly beneficial for ongoing expenses or projects. Unlike a cash-out refinance, a HELOC doesn’t require you to restructure your existing mortgage.
Personal loans are unsecured loans that don’t require any collateral, unlike a cash-out refinance, which uses your home as collateral. The primary advantage of a personal loan is the lack of risk to your home, making it a safer option if you’re uncertain about your ability to repay the loan.
Additionally, the approval process for personal loans is often quicker, since it doesn’t require an appraisal or extensive paperwork.
Cash-Out Refinance FAQ
What is the disadvantage of a cash-out refinance?
A cash-out refinance could lead to higher interest costs over the long term, especially if the new loan has a higher rate or longer term. Additionally, it puts your home at risk if you’re unable to manage the new loan payments, since the home is used as collateral.
What is the minimum credit score?
The minimum credit score for a cash-out refinance typically ranges from 620 to 680, depending on the lender. A higher score will likely grant better interest rates and terms.
What is the average cost of a cash-out refinance?
The average cost of a cash-out refinance often ranges between 2% and 5% of the loan amount, covering fees for appraisal, underwriting, and closing, among others. These costs can add up, potentially offsetting the benefits gained from the refinanced loan.
What is the maximum LTV for a cash-out refinance?
The maximum loan-to-value (LTV) ratio for a cash-out refinance typically ranges between 75% and 85%, depending on the lender and other factors. A lower LTV ratio is often preferred as it indicates more equity in the home.
What is a no-cash-out refinance?
A no-cash-out refinance, or a rate-and-term refinance, involves changing the interest rate and/or term of the existing mortgage without taking out additional cash. This type of refinance is primarily aimed at securing better loan terms or interest rates without accessing the home’s equity for cash.
Now that you understand the finer details of a cash-out refinance, along with the pros and cons, you can make an informed, confident decision on what to do next. Armed with this knowledge, you are well positioned to select the refinancing option that best aligns with your personal and financial goals.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.