The Beginner’s Guide to Cash-Out Refinance
Let’s say it has been years since you purchased your home and its equity has grown. Why not make the most out of this and use it to reach some of your other financial goals?
You can trade your home equity and pocket the difference in cash, which you can then use to pay off debts, invest in real estate, renovate your bedroom, or even start a business.
It can be a powerful tool to use. But what is it? How does it work? And are there any drawbacks to it?
Today, we’ve compiled the ultimate guide to a cash-out refinance for you!
What is cash-out refinance?
A cash-out refinance lets you tap your home equity for lump-sum cash. In simple words, you’re borrowing more than what you already owe on a home loan and take the difference in cash. This is a type of mortgage refinancing that lends you money to fund other financial goals.
As this is a refinancing program, you won’t have to make two separate payments each month. Instead, the cash-out refinance will simply replace your current home loan.
How much cash out can you get on a refinance?
The important question remains: just how much can you get from a cash-out refinance?
Well, it all depends on the value of your home. You can’t typically take out more than 80% of your home value following an appraisal, although the specific number may be different between lenders and situations.
Although if you have a VA loan, then you can cash out up to 100% of your home equity.
Cash-out refinance vs home equity loan
A cash-out refinance is very similar to a home equity loan, as both let you tap your home equity and take it out as cash. While a lot of people may confuse them for each other, they are quite different! How so?
A home equity loan is sometimes known as a second mortgage, as your current mortgage will be prioritized in the case of a foreclosure, while the home equity loan comes second. It is considered an additional mortgage, in comparison to a cash-out refinance that replaces your first mortgage.
You’ll also receive a lump sum in the beginning, but your current mortgage will not be paid for by this. The repayment period can be anywhere between 5-30 years.
Why choose a home equity loan over a cash-out refinance?
- You only need a small amount of cash from your equity
- You already have a low mortgage rate
- You can handle two monthly payments
- You have a high credit score
Why do you need a cash-out to refinance?
So, what are some of the most common reasons for people to get a cash-out to refinance? This is also important to know as some lenders will ask what you intend to use the extra cash for.
Home improvement projects
It’s always nice to upgrade your home, whether for a functional or fully aesthetic purpose. You can use the lump sum from your refinance to fund different projects.
College fees
You can also cash out a portion of your home equity to help pay for college tuition, books, and other related expenses.
Consolidate debt
Perhaps the best reason why you might want to get a cash-out to refinance is to consolidate any debts. Whether it’s for credit cards, credit lines, or other personal loans, they usually have a higher interest than mortgage rates.
Investment
Investing your money can be a great way to prepare for retirement and other financial goals. Some people may choose to take out some of their home equity and put them into stocks or bonds. With compounding interest, it might make sense to do so. Although be sure that you have researched the right options for your goals and know what the risks are.
Start a business
Finally, you can also use the cash from your home equity to start a small business. Maybe it’s a bakery you’ve always wanted to start, a clothing line, or any other venture. With a cash-out refinance, you can now fund these projects.
Benefits of a cash-out refinance
- You can use the cash for other purposes
As we’ve mentioned earlier, you can use the cashed-out equity for a variety of purposes, including to pay off a credit card debt, fund a personal project, or even invest in real estate. It’s the main reason why some people would choose cash-out over other types of refinance programs.
- Lower interest rate
Compared to other types of financial loans such as credit cards, personal, or even a home equity loan, a cash-out refinance can typically offer a much lower interest rate.
Not only that, maybe you bought your home when the mortgage rate was higher. If it has considerably lowered today, it makes sense to refinance your home loan so you can save more. Of course, if this is the case, you can consider getting a cash-out refinance or regular refinancing if you don’t need the extra cash.
- Mortgage interest deduction
There is also another advantage of a cash-out refinance if you will be using the cash to fund a home improvement project: tax deduction. This may include anything that improves your primary or rental home. This means that you may be eligible for a mortgage interest deduction!
- Improve credit score
It’s no secret that paying off credit card loans in full can substantially improve your credit score. So, using the cash from your home equity can be a good idea as it may drop your credit utilization ratio.
Drawbacks of a cash-out refinance
- Requires at least 20% equity
To qualify for a cash-out refinance, you need to have at least 20% of the home equity. If the price has dropped in your home area, or you’ve only recently bought the home with a small down payment, you may not be able to apply for this type of refinancing.
- Higher rate than other refinance types
The truth is that cash-out refinancing often comes with a higher interest rate than other types, especially rate reduction refinancing. This is even worse if you have a bad credit score, which will significantly drive up your rates.
- Closing costs
Much like other types of refinancing, a cash-out refinance also has closing costs that may add up. This is usually around 2 to 5% of the mortgage amount. If you decide to get a refinance, make sure that the saving potential is as least as much as this fee!
- Losing some home equity
The idea of getting cash first in exchange for your home equity may sound like a good idea. But in retrospect, borrowing from your home equity also reduces the profit you may gain if you decide to sell it.
Alternative options to cash-out refinance
Are you looking for something similar to a cash-out refinance? Here are some alternatives you might find useful:
- Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC for short, is a second mortgage loan where you can borrow an amount of money and the collateral is your home. Much like a credit card, you will pay it back with interest, according to the agreement.
- Personal loan
You can get a personal loan from banks, credit unions, or other lenders, and it doesn’t require collateral. The benefit is that you won’t be risking your home. However, this means the rates are usually higher than a secured loan; it also has a shorter term.
- Credit card
Everyone is familiar with credit card loans. Although it’s the solution if you need something quick, we recommend keeping the credit card for the last possible solution. This is because credit cards charge a much higher interest rate than the options we have mentioned today.
- Reverse mortgage
For those aged 62 or above and have a minimum of 50% home equity, a reverse mortgage can be a great option. This allows you to receive cash as a lump sum, line of credit, or even monthly payment.
At the end of the day, a cash-out refinance is a versatile option for those of you who want to pay off high-interest debts or upgrade your kitchen. It can give you enough money to fund your goals.
Don’t hesitate to talk to an advisor to discuss your goals and options, so you can make the smartest financial decision depending on your circumstance. Good luck!