Getting Ready for a Cash-Out Refinance? Read This First!
Despite current interest rates not being as low as everyone might like, refinancing is still on the table for a good number of homeowners, but especially for those who are thinking about doing a cash-out refinance for home improvement purposes.
Refinancing to pay for certain home improvements or renovations can make sense even when interest rates are slightly higher than what you wish because the completed projects can increase your home’s market value, which will in turn potentially increase your equity to the point that you can remove private mortgage insurance from your monthly payment. This will help offset the increase in your payment amount caused by the higher interest rate.
Of course, if you want your cash-out refinance to provide you with the best all-around results, you need to be careful to avoid making a few common mistakes that could wind up costing you more money. Here are five of the most common mistakes made by homeowners doing cash-out refinances.
#1: Not Taking the Costs of Refinancing Into Account
When you do a cash-out refinance, you’re not only getting a new loan to pay for your old home loan, but you’re also using some of your home’s equity to secure an additional amount that will serve as the cash you get back. This means that you’re making your home loan larger, and this will increase the total costs of repaying your new mortgage.
You also need to consider the up-front costs of refinancing. Some of the things you’ll have to pay for include the mortgage origination fee, appraisal costs, the cost of a credit check, title insurance fees, and a variety of other fees and associated expenses. When totaled, these extra fees can add up to several thousand dollars.
Luckily, your lender will disclose the costs of refinancing your loan before the process starts, so you’ll know what you’re looking at. Just make sure you keep these costs in mind when determining if refinancing your current home loan makes sense.
#2: Using Too Much Equity
As stated previously, the “cash-out” portion of your new loan comes from the equity you’ve gained in your home since purchasing it. So, your home’s equity will be reduced by whatever amount you are taking out as cash. This can be risky should you use too much of your equity.
Using too much equity can potentially make you “underwater” on your home, which is when you owe more than it’s worth. This can make it more difficult to refinance in the future or affect your ability to sell your home.
It’s also important to remember that if your cash-out refinance results in the amount of your new loan being above 80% of your home’s value, you will most likely find yourself paying for private mortgage insurance (PMI) once again.
#3: Refinancing When Your Financial State Isn’t Great
Doing a cash-out refinance follows all the same steps as when you were approved for your original home loan. As a result, you need to meet or exceed all the required criteria to secure the lowest rate possible.
Should you decide to refinance before you get your financial house in order, then you could wind up with a much higher interest rate and a much bigger monthly payment. Before you apply, make sure your credit score is good, your income is stable, and your debt-to-income ratio is below 45% (for a conventional mortgage).
#4: Using the Cash for the Wrong Reasons
A cash-out refinance can be highly attractive because it provides you with access to a large sum of money. And while the lender might ask you what you intend to do with it, you are not bound to use it for any single purpose. Still, some uses make better financial sense than others. Remember that your home is what is at risk should you default on your loan, so you will be best served to use the money wisely.
Using the money for home improvements is a great idea because it increases your home’s value and restores your equity quicker. There are also tax advantages to using the money for certain home improvements.
But if you use the funds to pay off credit card debt, you could be taking on added risk because credit card debt is unsecured. Should you be unable to pay your credit cards, your credit history will be damaged but nothing will happen to your home. But if you pay off your credit cards with your cash-out refi, then you risk losing your home if you can’t make your loan payments. Plus, there is always the real possibility that you might use your newly paid off credit cards again, thus making your total debt even higher.
#5: Failing to Compare Lenders
From brick and mortar mortgage businesses and traditional banks to credit unions and online lenders, today’s homeowners have an abundance of options available to them for choosing where to get a mortgage loan. With so many options, it’s important to do your due diligence by researching lenders and comparing offers. You might be surprised to discover that your current mortgage lender isn’t the best one to use for your cash-out refinance. To help ensure that you’re getting the best loan for your purposes, get quotes from multiple lenders before selecting one.
When you do a cash-out refinance, you’re swapping out your current loan for one that is larger, so there is always a certain level of risk in doing it. That said, avoiding these five common mistakes can help make your experience more rewarding and the results of your cash-out refinance all the better.
