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What Is a Cash Out Refinance and How Does It Work?

You build up equity when you buy a home and pay down your mortgage, with that equity being the portion of your home you own. If you’re short on cash, a cash-out refinance lets you access this equity in the form of a new loan. It gives you access to money without the need to pay off your mortgage or sell your house. Learn more about how cash-out refinancing works to see if it’s a good option for you.

What is Cash-out Refinancing?

Simply put, cash-out refinancing allows you to borrow from what you’ve already paid toward your mortgage. Every mortgage payment you make increases your equity in your home — the percentage of the home you own.

Cash-out refinancing allows you to borrow from that equity by taking out a new mortgage. You receive a cash payment for what you’ve paid into your mortgage or any equity you may have on your home that you want to borrow. Your new mortgage loan may be T he same amount as your old one, including the remaining balance you owe and whatever you borrowed.

This method changes the original terms of your loan. Therefore, you might pay a different interest rate. For example, if interest rates have dropped since your original loan, a cash-out refinance allows you to reduce your rate while also getting access to capital.

Here are some additional reasons why a cash-out refinance can be a good choice for some homeowners:

  • Your borrowing costs could be lower than other methods of refinancing or taking out a new loan.
  • You can reduce your credit utilization ratio and improve your credit score if you use the cash to pay off debts.
  • You may be eligible for tax deductions if you use the cash for home improvements.

How Does a Cash-out Refinance Work?

Imagine you initially took out a mortgage for $250,000. You’ve paid off $100,000 of your mortgage, leaving you with a $150,000 balance, and you need $25,00 to renovate your kitchen.

With cash-out refinancing, you could take out a new loan for $175,000. This amount covers your remaining owed balance in addition to the money you need for your renovation.

In many cases, banks don’t let you cash out the entirety of the equity you’ve built up. Instead, lenders usually let you borrow up to 80% of your home’s equity. Using the same example, you’d be able to cash out a total of $80,000 (for a new loan of $230,000). This quality prevents you from starting at square 1 with your mortgage while helping the lender feel more confident that you can eventually repay the loan.

Advantages of a Cash-out Refinance on Your Mortgage

There are several benefits to choosing a cash-out refinancing, including:

  • You can access cash from your equity: Mortgage interest rates are usually more affordable than other types of loans, allowing you to avoid high-interest credit cards and personal loans.
  • You can use the money to pay off high-interest debt: If you have high-interest debt,  cash-out refinancing could help you pay it off faster. Make sure to do the math before committing, as sometimes the closing costs of the new loan can cancel out your savings.
  • You can lower your tax burden: Many homeowners use funds from a cash-out refinance to renovate their property. If you go this route, you can deduct the interest you pay on these funds. The IRS allows you to deduct up to $1 million in mortgage debt if you purchased your home before December 16, 2017. If you purchased after then, the limit is $750,000.
  • You can have predictable payments: Because many cash-out refinance loans offer fixed rates, your payment remains stable throughout the loan’s lifetime.
  • You can improve your home’s value and increase your equity. Using the funds from your cash-out refinance to renovate and improve your home may increase its value.

Disadvantages of a Cash-out Refinance on Your Mortgage

There are also a few drawbacks to consider. Here are some reasons to be hesitant about a cash-out refinance:

  • You have to pay cash-out refinancing closing costs: Refinancing with cashback isn’t free. Like when you took out your original loan, you must pay closing costs. Experts estimate you could pay between 3% to 6% of your outstanding principal in refinancing fees.
  • You reset your mortgage: When you cash out your mortgage, it undoes your progress toward owning your home outright. Additionally, your amortization resets as well, with the majority of your monthly payments going toward interest instead of principal.
  • You need 20% equity in your home: Many lenders want you to have 20% of your home’s value paid off. While the traditional down payment used to be 20%, these days, Federal Housing Administration (FHA) loans let you put down as low as 3.5%. If you took advantage of this deal, it might be a while before you can do a cash-out refinance.
  • You could lose money if you plan on selling soon: If your goal is to sell in the next couple of years, cash-out refinancing might not be a good idea unless you’re using the funds to make improvements to your home to increase its value.
  • You could get a higher interest rate: Cash-out refinancing rates tend to be slightly higher than traditional mortgage rates. However, they are usually still lower than other types of loans.

How to Get a Cash-out Refinance on Your Mortgage

The process of cash-out refinancing is similar to applying for your mortgage. Start by shopping around with different lenders to see who has good terms and rates. When you decide on a lender, double-check its requirements to ensure you are eligible. Then, consider how much cash you want to take out of your equity. The final step is filling out an application and getting approved for your new loan.

Consult the Requirements for Cash-out Refinancing

Lenders typically have strict requirements regarding who may be eligible for cash-out refinancing. The first thing to consider is your credit score. It varies significantly between lenders, but many want you to have a fair score of 620 or higher. However, if you take out a Veteran Affairs (VA)-backed or FHA loan, you might be able to refinance with a score as low as 580. The higher your score, the better terms you may be able to secure.

Another important factor is your debt-to-income (DTI) ratio. DTI is the monthly debt you have compared to your monthly income. The ideal percentage is 43% or less. As an example, imagine that you make $4,000 a month. In this instance, lenders don’t want you to have more than $1,720 in debt each month. That includes mortgage payments, credit card debt, and student loans.

The existing equity you have in your home also plays a significant role. Lenders want you to have 20% or more equity in your home. This level of equity proves you’ve been reliable at making payments and strengthens your case that you can handle an additional loan.

Finally, lenders factor in your loan-to-value (LTV) as well. LTV is your new loan’s value compared to your new home’s value. Standard lenders typically cap new loans at 80% of the home’s value. Therefore, if you own a house worth $500,000, the highest amount you could refinance for would be $400,000, ensuring you maintain 20% equity in the home. To secure better rates, keep your LTV ratio on the lower end.

You might have a little more wiggle room if you have an FHA or VA-backed loan. The FHA can sometimes let you borrow up to 85% of your home’s value, while the VA lets you borrow 100% of your home’s value.

Calculate the Amount You Need

Traditional lenders let you borrow up to 80% of your home’s value, but it is better to take less. Before you sign the paperwork, do some calculations to see how much you require. If you want the money for a home improvement project, get several estimates from local contractors to see your average costs. If you’re doing the work yourself, price out the supplies you need with a slight cushion for inflation.

Some people also use cash-out refinancing to pay off debt. To do this, gather your financial information and calculate precisely how much you need to settle your debts. It might help to talk with a financial advisor so they can guide you through this process.

No matter what you want to use the cash for, it’s a good idea to carefully consider your needs before you proceed with your new loan. Taking out too little could leave you stuck in the middle of a project or create more debt than you started with. On the other hand, taking out too much could reduce your stake in your home without gaining you anything.

Apply For Cash-out Refinancing

The process of applying for a cash-out refinance varies depending on your existing loan and the new type of loan you choose. Still, the process is relatively the same. Your lender might want to see proof of your financial history. The will likely request:

  • W-2 statements
  • Tax returns from the past couple of years
  • Pay stubs
  • Bank account statements
  • PayPal or Venmo statements

You might need to provide previous mortgage paperwork and statements if you’re taking out your new loan from a different lender. If you have other debts, like credit card debt or student loans, your bank might want to see statements showing how much you owe. This information proves that you’ve been making on-time payments and can also be used to verify your DTI ratio. 

Finally, your bank might want to verify your score and investigate any additional factors from your financial history.

How to Get the Best Refinancing Rates

If your goal is to find and secure low refinancing rates, there are a few things you can do to improve your chances. These include:

  • Improve your credit score: The higher your credit score, the more favorable your loan terms. Using the FICO Score ranking, a score between 670 and 739 is considered good, while a score between 740 and 800 is very good. To improve your credit score, pay as many outstanding debts as possible, reduce your spending, and make sure you’re on time with payments.
  • Reduce your LTV: The more equity you pull from, the bigger your new loan — and your LTV — becomes. Banks don’t like high LTVs because they could lose more money if you default on your loan. To compensate for this additional risk, they sometimes increase the interest rate. That’s why you might want to cash out precisely what you need and no more.
  • Try a shorter-term loan: The traditional mortgage lasts 30 years, but you may not need that long to pay off your new loan. Banks sometimes have lower interest rates for 10- or 15-year loans, so take advantage of that if you can.
  • Shop around with different lenders: Getting cash-out refinancing quotes from 3 to 5 lenders is a good idea. Sometimes, even though a lender is offering what appears to be a super lower interest rate, they tack on additional fees that make the loan more expensive than another option.

Other Options to Consider

A cash-out refinance isn’t your sole option for freeing up some cash. There are a few additional loan products to consider, including home equity loans, HELOCs (home equity lines of credit), and personal loans. You may have heard the term “second mortgage” before; that’s what home equity loans and HELOCs are. They involve taking out a second loan in addition to your mortgage. Personal loans offer collateral to the lender but are not linked to the home.

Consider the preceding options to avoid altering your mortgage and paying additional closing costs. While taking that route may save you money in the long run, there are several things to remember before pursuing those paths.

Cash-out Refinancing vs. Home Equity Loans

Unlike cash-out refinancing, a home equity loan does not include your mortgage. The second loan you take out is solely for the cash you need. This strategy keeps your mortgage and your new loan separate.

With a home equity loan, you also utilize the equity you’ve built up in your home as collateral. You still have to maintain 20% equity in your home, so you can’t take out more than 80% of your home’s value.

People might choose a home equity loan over cash-out refinancing if they have a low-interest rate on their current mortgage. With a home equity loan, they could lose that low rate and possibly end up paying quite a bit more for access to their equity.

A home equity loan can also be a good idea if you’re close to paying off your original mortgage. Getting a new mortgage toward the end of your term resets amortization, meaning you have more upfront interest. When you’re near the end of a loan, most of your payments go toward the principal, so it makes more sense to keep that loan separate instead of rolling it into a new loan where most payments go toward interest.

Cash-out Refinancing vs. HELOCs

HELOCs are similar to cash-out refinancing and home equity loans in that they let you borrow from the equity you’ve built up. However, with a HELOC, you don’t take out a new loan or mortgage. Instead, it works more like a revolving line of credit.

You can pull out small amounts over a longer period, usually around ten years. During this time, you usually don’t have to make repayments on your total balance — simply the accumulated interest. However, once your draw period ends, you enter the repayment period, where you must repay everything you’ve borrowed plus interest over a specific term (usually 20 years). 

HELOCs are an option for those who don’t need a huge lump sum to pay a contractor or reduce their debt. For example, if you plan on slowly upgrading parts of your home over the next few years, a HELOC can give you access to cash when you need it.

However, because HELOC interest rates are usually variable, your monthly payments might change over time, meaning they’re not a great option if you are on a fixed monthly budget.

Cash-out Refinancing vs. Personal Loans

Cash-out refinancing is tied directly to the value of your home. With a personal loan, the equity you have in your home may be an essential factor, but it’s not the sole consideration.

Personal loans do not affect your home’s value, and you can use the funds for whatever you’d like. Before giving you a personal loan, a lender looks at your financial history. They might consider your credit card debt, student loans, and mortgage debt and how taking on a new loan would affect your financial health. Like with a cash-out refinance, lenders likely want you to have a DTI of 43% or less.

But because your home isn’t the primary collateral source, you may be able to use other possessions or holdings to secure your loan. For example, banks may consider your assets like vehicles, investments, and businesses you may own when determining your loan eligibility.

A personal loan might be a better option if you don’t have equity in your home. Also, personal loans can be a good choice if you don’t want to change your already low mortgage rates or pay additional closing costs. However, consider that personal loans usually have much higher interest rates than other home-based loans, including cash-out refinances.

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