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Cash-Out Refinance: When Is It the Right Option?

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If your home’s equity has grown and you want to put it to use to improve your finances or your home, it might be time to consider a cash-out refinance. You can borrow more than you currently owe on your mortgage, pocket the “cash out” to pay off debts or spruce up that outdated kitchen or cover a big expense like college tuition.

A cash-out refinance may be a good financial tool, as long as you know how it works, and understand the pros and cons.

How does a cash-out refinance work?

It takes a little extra legwork to complete a cash-out refinance versus a regular refinance. In most cases, you’ll follow five steps to convert your home’s equity to cash:

  1. Verify you can afford the loan. Because you’re taking out a larger loan than you currently owe, lenders will vet your income, assets and credit to verify you can make the higher payment.
  2. Verify how much your home is worth. A home appraisal is generally required to confirm your home’s value. A licensed real estate appraiser compares your home to recent nearby sales with similar features and provides an opinion of value.
  3. Verify how much you currently owe. A title company requests a payoff from your current mortgage company to verify the outstanding balance and provides it to your lender so they can calculate the principal and interest due at your closing.
  4. Verify the maximum you can borrow based on the loan program. Standard mortgage programs allow you to borrow up to 80% of your home’s value. This is also called your “loan-to-value” (LTV) ratio maximum, which measures how much of your home’s value is being borrowed. However, eligible military borrowers may tap up to 90% of their home’s value with a VA loan.
  5. Subtract closing costs and what you owe from your maximum loan amount. With your appraisal in hand, the lender will finalize your total cash out after deducting your current mortgage balance and any closing costs (which usually run between 2% to 6% of your loan amount).

Cash-out refinance example

The table below shows a cash-out refinance in action, assuming your home is worth $300,000, you currently owe $150,00 and plan to borrow 80% of your home’s value, and pay $5,000 in closing costs.

Home’s appraised value $300,000
80% of your home’s value $240,000 ($240,000 x 0.80)
Subtract current mortgage balance -$150,000
Subtract closing costs -$5,000
Total cash to you $85,000

How much can you get from a cash-out refinance?

The best cash-out lenders typically offer these three common mortgage programs:

Conventional loans. With guidelines set by Fannie Mae and Freddie Mac, you’ll be able to borrow up to 80% of your home’s value. A bonus: You won’t pay mortgage insurance, which provides lenders with financial protection if you default on your home loan.

FHA loans. Backed by the Federal Housing Administration (FHA), FHA loans allow you to borrow up to 80% of your home’s value with credit scores as low as 500. The catch: You’ll pay expensive FHA mortgage insurance regardless of how much equity you have.

VA loans. Designed for eligible military borrowers, the U.S. Department of Veterans Affairs (VA) guarantees cash-out refinance loans up to 90% of the home’s value.

Reasons to consider a cash-out refinance

Lenders will ask you what you’re using your extra cash for. Some common purposes of a cash-out refinance include:

Funding home improvements. The lump sum from your cash-out refinance could pay for a bathroom or kitchen remodel.

Consolidating debt. You can replace high-interest credit card debt balances, personal loans or credit lines with a lower interest rate mortgage.

Paying for college. Extra cash from your home equity may help cover tuition, books or other higher education expenses for you or your student.

Starting a small business. You may decide to tap home equity to start that bakery, boutique or other business you’ve previously put on hold.

Buying an investment property. You could use your home equity to cover the down payment for a rental property that generates monthly income.

THINGS YOU SHOULD KNOW

Unless you use your cash-out refinance funds for home improvements and can document the expenses, the mortgage interest on your cash-out equity isn’t tax-deductible.

Pros and cons of cash-out refinance

Pros

  You can use the cash-out equity for any purpose. Whether it’s paying off some credit card debt or starting to invest in real estate, your home equity can be used as you see fit.

  You can expect a lower interest rate compared to other financing options. Mortgage rates are typically lower than credit cards, personal loans or home equity loans, which puts more room in your monthly budget.

  Your interest charges may be tax-deductible. If you use your funds for home improvements on a primary residence or rental home, you may get a break when you file your taxes.

Cons

  You’ll need at least 20% equity to qualify. If home values have tumbled in your area or you recently purchased with a small down payment, a cash-out refinance may not be possible right now.

  You’ll lose some of the equity you’ve built. Borrowing against your home equity now means you’ll make less profit when you sell your home

  You’ll have a higher monthly mortgage payment. Even if you’re consolidating debt with your cash-out refinance, a higher loan amount means a higher monthly mortgage payment for as long as you own your home.

  You may pay a higher rate than other types of refinance. Cash-out refinance rates are typically higher than rate reduction refinances. If you have a low credit score, you can expect an even higher rate if you’re tapping equity.

THINGS TO KNOW:

Calculating the break-even point for a refinance tells you when you’ll recoup your costs and start saving money. If you’re cashing out equity, how you calculate the breakeven depends on what you’re using the cash for.

If you’re consolidating debt, add the monthly payments of the accounts you’re paying off, and then divide the savings by your closing cost — the result is  how long it will take to recover your refinance closing costs. With a cash-out refinance for home improvement, if your home’s value increases by more than the cost of the improvements, then the refinance is probably worth it.

How to qualify for a cash-out refinance

If you have enough equity to qualify for a cash-out refinance, you’ll also need to meet the cash-out refinance requirements for income, credit and assets set by each program. Lenders will pay close attention to the following five factors when considering whether or not you can afford a bigger loan.

Cash-out credit score requirements.  You may need to stick with a government-backed FHA loan if your scores are below the 620 cash-out refinance credit score set by conventional guidelines. Some lenders may set a higher credit score requirement for their cash-out refinance products.

Debt-to-income (DTI) ratio. Your DTI ratio is a measure of your total debt divided by your pretax income, and it carries a lot of weight when you’re borrowing more than you currently owe. The Consumer Financial Protection Bureau (CFPB) recommends a DTI ratio of 43%, but lenders may make exceptions if you have high credit scores or extra savings.

The purpose of your refinance. While lenders don’t restrict what you can do with your cash-out refinance money, they will ask if the extra money is being used to create new debt. For example, if you get a cash-out refinance to buy investment property, the lender will need to document the new mortgage terms to make sure you qualify with the rental home payment.

The occupancy of the house you’re refinancing. Most borrowers take cash out of their primary residence — that is, the home they live in all the time. However, conventional loans also allow you to borrow money against the equity in an investment home or second home. In most cases, you’ll pay a higher interest rate and be limited to a lower LTV than a primary residence cash-out refinance.

The number of units in your home. You’ll get the most cash out of a one-unit, single-family home; lower LTV limits apply to two- to four-unit homes.

The table below gives you a glance at the qualifying requirements for different loan types, assuming you’re taking cash out of a primary residence single-family home.

Conventional FHA VA
Minimum credit score 620 500 620
Maximum DTI ratio 45%-50% 43% 41%
Maximum cash-0ut LTV ratio 80% 80% 90%

Cash-out refinance vs. home equity loan

A cash-out refinance is not the only way to tap your equity; another option is a home equity loan. A home equity loan is simply a loan against a portion of the equity in your home. Instead of taking out a large loan to pay off your current mortgage, you take a smaller loan for the amount of equity you want to use. The funds are received in a lump sum and repaid on a fixed installment schedule ranging from five to 30 years.

Home equity loans are also called second mortgages because they’re second in line to be paid — after your current first mortgage — if you lose your home to foreclosure.

A home equity loan may make more sense than a cash-out refinance if:

  • You’re borrowing a small portion of your home equity
  • You want to leave your current low-interest-rate mortgage alone
  • You need to borrow more than the 80% limit set by most first mortgage cash-out mortgage programs
  • You don’t mind making two monthly mortgage payments
  • You have a high enough score for approval than a cash-out refinance requires

Cash-out refinance alternatives

Besides the home equity loan option discussed above, here are a few other alternatives to a cash-out refinance:

  • Home equity line of credit. A HELOC is another type of second mortgage that initially works like a credit card, except it’s secured by your home. You receive a credit line and only make payments based on how much you borrow, plus interest.
  • Reverse mortgage. Homeowners age 62 years and older with at least 50% equity in their home can convert their equity into cash, a line of credit or receive monthly payments with a reverse mortgage. No monthly mortgage payment is required.
  • Personal loan. An unsecured personal loan typically comes with a higher rate and shorter repayment term options compared with a cash-out refinance, but your home wouldn’t be used to secure the loan so there’s no risk of losing it if you default.
  • Credit card. While it can help in a time crunch, a credit card should be a last-ditch effort to access the funds you need since they usually have higher interest rates than the options above.

Cash-out refinance FAQs

HOW LONG DOES IT TAKE TO GET YOUR MONEY FROM A CASH-OUT REFINANCE?

It can take several days after your refinance closes to receive your cash. There’s a three-business-day right of rescission on refinance loans, which allows you to cancel the transaction for any reason. If you decide to move forward, your new lender will then pay off your old loan and you’ll receive your cashed-out equity after that point.

DOES A CASH-OUT REFINANCE AFFECT MY CREDIT SCORE?

Since you’re taking out a new loan to replace your existing mortgage, your credit score and history will be impacted. New credit makes up 10% of your credit score and affects the length of your credit history. This change typically causes a drop in your credit score.

WHAT IS A LIMITED CASH-OUT REFINANCE?

A limited cash-out refinance also replaces your current mortgage, but only for a slightly higher amount to cover the closing costs. You’re allowed to receive up to $2,000 or 2% of your new loan amount in cash, whichever is less. The cash doesn’t come from your home equity, but from the difference between the estimated and final loan payoff amounts.

CAN I SELL MY HOUSE AFTER A CASH-OUT REFINANCE?

Yes, you can sell your home after going through the cash-out refinance process. However, it’s best to calculate your break-even point before selling. If you decide to sell before you recover your costs, you’ll essentially lose money with a refinance.

CAN YOU GET A CASH-OUT REFINANCE ON A SECOND HOME?

Yes, you may qualify for a cash-out refinance on a second home or an investment property, but you won’t be able to borrow as much equity. Lenders limit the LTV ratio for cash-out refis on second homes and investment properties to 75%, meaning you’ll need at least 25% equity after closing.

HOW DOES A CASH-OUT REFINANCE AFFECT YOUR TAXES?

A cash-out refinance may impact your mortgage interest deduction, which allows you to deduct the loan interest you paid over the year from your taxable income. Unless you use your cashed-out equity to cover a home improvement project on the primary or investment home that secures the refinanced loan, you won’t be able to deduct the interest you pay on that portion of your loan. You may still deduct the interest paid on the remaining portion of your loan, though.

 

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