Is a Cash-Out Refinance the Right Mortgage Product for You?
Need extra money? Have at least 20% equity in your home? If you answered yes to these two questions, then you’re probably considering a cash-out refinance. But do you know how a cash-out refinance works?
Before you start applying for a cash-out refinance, you should learn all there is about it, so you can make the best decision for your current and future financial goals. Here’s everything you need to know about cash-out refinances, including how they work, their requirements, and more.
What is a Cash-Out Refinance?
Unlike with a standard mortgage refinance, a cash-out refinance provides you with a new loan in an amount that is higher than what you owe on your current mortgage. The difference between what you owe on your original loan and the amount of the new one is the amount that you receive in cash at closing. How much cash you can access all depends on how much equity you have in your home, or in other words, how much your home is valued at compared to how much you owe.
Here’s an example:
If your home is valued at $300,000 and your mortgage balance is $100,000, then you have $200,000 of equity in your home. If you get a cash-out refinance with a new loan of $150,000, then you will receive the $50,000 in cash at closing.
Requirements for Cash-Out Refinances
Qualifying for a new home loan for a cash-out refinance means that you will have to meet the lender’s requirements, which by and large are the same requirements as when you had to qualify for your original loan, with a few exceptions.
For instance, your lender will usually require:
- Debt-to-income (DTI) ratio of no higher than 45%
- Credit score no lower than 620
- Must have owned home for at least six months
- Must have at least 20% equity in the home
Traditional lenders will usually require you to borrow no more than 80% of the equity you have in your home, though this can vary by lender and the type of loan. However, if your mortgage is backed by the Department of Veterans Affairs, for example, then you may be able to borrow up to 100% of your equity with a VA cash-out refinance.
Pros and Cons of Cash-Out Refinances
It can be tempting to borrow against the equity in your home, and there can be a lot of advantages to doing so when everything lines up right. But it’s important to consider this decision carefully as there can also be disadvantages if you aren’t careful. Here’s a brief breakdown of the pros and cons of cash-out refinances.
Pros of Cash-Out Refinances
- Access to substantial funds: The whole purpose of a cash-out refinance is to access a large sum of money to help with certain major expenses, like a home renovation or college tuition. So, this is the obvious pick for the top benefit.
- Possible lower interest rate: Cash-out refinance rates tend to be slightly higher than standard refinance rates, but depending on what your current rate is, you may still end up with a lower rate if your credit score is high enough and the national interest rate is low.
- Debt consolidation: While using a cash-out refinance for debt consolidation purposes isn’t exactly the best use for the money, because it leaves you open to certain risks, it can be beneficial if you are very, very careful with managing your debt after you pay off your high-interest credit cards. After all, if the rate on your new home loan is lower than your credit cards, then you could save thousands of dollars in interest over the long term. And with your credit cards paid off, your credit score will rise because your debt-to-income ratio will fall.
Cons of Cash-Out Refinances
- Foreclosure risks: Just like with your original mortgage, your home is the collateral for your cash-out refinance. This is always risky, but when you take a cash-out refinance to pay off credit card debt, you’ll be paying off your unsecured debt with secured debt. Should you miss your mortgage payments, you would wind up losing your home to foreclosure.
- Longer loan term: When you take a cash-out refinance, you are essentially restarting the clock on your mortgage. If you have ten years left on your current mortgage, and you refinance into a new 30-year mortgage, you’re adding another 20 years onto your payment obligation. Those years will see you spending a lot more for your home, despite possibly getting a lower rate.
- Time to access the cash: Taking a cash-out refinance doesn’t take as long as it does to get a regular mortgage, but it still takes time because it has to go through underwriting. As a result, if you need quick access to the money, then you might want to find an alternative to a cash-out refinance.
- Closing costs: A cash-out refinance requires you to pay closing costs, which can be anywhere from 2% to 5% of the loan amount. If you are using the cash you are getting from the equity in your home to pay those costs, then you could wind up getting a lot less money than you expect.
- Private mortgage insurance: One of the best things about having 20% equity in your home is that you no longer need to pay for private mortgage insurance (PMI). But, if you borrow more than 80% of your home’s value, then you’ll once again have to pay for private mortgage insurance, and this can make your monthly payment higher than you expected.
Is a Cash-Out Refinance a Good Idea?
Whether or not a cash-out refinance makes sense all matters on a few select factors, such as the interest rate and terms of the new loan and what you plan to do with the money. Because of the increased risks, you want to ensure that you get the best return on the money. For instance, using the money to pay for a vacation is a terrible idea because once the money is spent, it’s gone. But on the other hand, using it to pay for a home renovation will allow you to quickly rebuild the equity you’re taking out.
If you have questions or concerns about taking a cash-out refinance, then it’s always recommended that you speak with your lender. They can provide you with professional advice and guidance that will help you determine if applying for a cash-out refinance makes sense for you at this time.
