If the value of your home has increased since you purchased it, and you want money to remodel or renovate, a cash-out refinance can be a smart option. A cash-out refinance allows you to use the equity built up in your home by taking out another mortgage to pay off the first and getting the difference in cash.
However, it’s essential to understand how a cash-out refinance works before taking one out, as some risks are involved. Learn more about cash-out refinance mortgages to help you decide if this financial move is the right one for you.
What is a Cash-Out Refinance?
A cash-out refinance is a mortgage refinance option where you take out a new, larger mortgage loan to replace your existing mortgage, then take the cash equal to the equity you have in your home.
Cash-out refinancing differs from a regular refinance because you aren’t taking out a new mortgage to gain a better rate or term refinance; instead, you are taking out a loan in excess of the original loan so you can have access to a lump sum of cash.
Cash-out refinances can be beneficial because they allow you to access equity built up in your home without selling it or taking out a second mortgage. Cash-out refinances are available in both fixed-rate and adjustable-rate mortgage options.
How to Qualify for a Cash-Out Refinance?
Cash-out refinance is a great way to access the equity in your home and use it for major expenses, such as home improvements, medical bills, or college tuition.
To qualify for a cash-out refinance, you’ll need to have built up enough equity in your home so that the new loan amount is less than 80% of the home’s value. You’ll also need a good credit score, a low debt-to-income ratio, and a steady income.
Once you’ve met these qualifications, you can apply for a cash-out refinance through your lender. If approved, you’ll be able to take out new rates and terms for refinancing for the amount you want, minus any closing costs.
Ensure you have a plan for funds gained through a cash-out refinance. A cash-out refinance is still a mortgage, and you’ll be responsible for making monthly payments until the loan is paid off.
The Benefits of a Cash-Out Refinance
Whether you’re looking to consolidate debt, make home improvements, or have some extra money, a cash-out refinance can be an excellent strategy. Key benefits of using cash-out refinance include:
- Lower interest rate. If you currently have a high-interest loan, consolidating into a cash-out refinance can help you save on interest payments. When you refinance for a lower interest rate, you pay less over the life of the loan.
- Extend your loan term. A cash-out refinance can allow you to extend your loan term, reducing your monthly payments.
- Access your home’s equity. A cash-out refinance lets you access the equity in your home, which can be used to pay off credit card debt, build an addition to your home, or fund an important vacation or life event.
The Risks of a Cash-Out Refinance
There are some risks to consider before deciding to take out a cash-out refinance. Potential drawbacks include:
- Upside down mortgage. If the market fluctuates and the value of your home drops, you could end up owing more than it’s worth.
- Higher interest rates. If you choose a variable-rate mortgage for the refinance, you may have a higher interest rate on your loan. Variable rate mortgage interest rates change with the market, and if they increase, you’ll owe more over the life of the loan.
- Significant closing fees. Closing costs can add up, and like a traditional refinance, these fees are typically 2% to 5% of the loan. If you don’t plan for closing fees when determining your cash-out refinance amount, you may get less cash back than you anticipated.
How to Know if a Cash-Out Refinance is Right for You?
Cash-out refinances typically have higher interest rates than regular refinances because they involve additional risk for lenders. When you take out a cash-out refinance, you’re lengthening the term of your loan and increasing your total interest costs over time.
To determine whether a cash-out refinance is the right move for you, ask yourself the following questions:
What Are Your Current Financial Goals?
A cash-out refinance can provide access to much-needed funds, but it’s essential to make sure that the funds will be used in a way that’s consistent with your long-term financial goals. If you’re trying to save for retirement or reduce your overall debt load, avoid using the money from a cash-out refinance to make purchases like a vacation or a new car.
How Much Equity Do You Have in Your Home?
A cash-out refinance lets you get cash by tapping into your home’s equity; however, there may be better options available if you don’t have much equity. For example, credit cards or personal loans may give you access to funds you need for a smaller home improvement project if you don’t have a lot of equity in your property.
What is Your Current Interest Rate?
If you’re currently paying a high interest rate, it may make sense to refinance into a loan with a lower rate. But if rates have gone up since you initially financed your home, you could end up with a higher rate by doing a cash-out refinance.
Is There Another Way to Access the Cash You Need?
There are other ways to get the cash you need without resorting to a cash-out refinance. If you have good credit, you may be able to take out a personal loan or use a credit card. These options typically have shorter terms than a cash-out refinance, but they require you to make regular payments.
How Long Do You Plan to Stay in Your Home?
A cash-out refinance has closing costs and other fees that must be paid upfront, so it generally doesn’t make sense unless you plan to stay in your home for several years. You may end up paying more in interest and fees than you would by selling your home and taking out a new loan on another property.
It is essential to consult with a financial advisor before making any major decisions about your mortgage.
Alternatives to a Cash-Out Refinance
You have several alternatives to a cash-out refinance to obtain the necessary funds. The most common financial products and services offered by lenders are:
Home Equity Line of Credit
With a home equity loan, you can borrow against your home equity with a variable interest rate. This option may be more flexible than a cash-out refinance, but it can also be more expensive if interest rates rise over time. 20-year loans also called 20 equity for lines of credit (HELOCs), is the most common term for this financial tool.
A personal loan from a bank or credit union can give you access to funds at a fixed interest rate. Personal loans typically have shorter repayment terms than mortgages, so they may not be ideal for large expenses.
Using credit cards to finance expenses can be costly if you don’t pay off your balance in full each month. However, some credit cards offer 0% intro APR periods, which can offer substantial savings on interest if you can pay off your balance before the intro period expires.
Tapping into your savings is usually the least expensive option, but it may not be possible if you don’t have enough.
Consider a Cash-Out Refinance as a Viable Financial Tool
A cash-out refinance is a popular way to consolidate debt, make home improvements, or pay for unexpected expenses. You must have enough equity in your home to qualify for the cash-out refinance.
You’ll want to consider the costs of the refinance, including closing costs and any prepayment penalties associated with your current mortgage, before going through with the transaction.
Learn more about refinancing your home, and other mortgage topics at Finance is us.
Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.