Cash-out refinance loans replace your current mortgage with a new loan for more than what you owe on your home.
The extra money you receive can be used for home renovations or repairs.
In order to be able to get a cash-out refinance you need to have equity in your home.
Most lenders are able to refinance your loan up to 80% of the current market value of the property.
For example: Your home is valued at $200,000 and your mortgage balance is $100,000. You can get a cash-out refinance for up to 80% of the value, in this example that is $160,000. $100,000 will go to pay off your current lender and the remaining $60,000 goes in your pocket. You now have one payment on a $160,000 loan.
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Cash out Refinance Pros and Cons
A cash out refinance is one of the cheapest ways you can borrow money. The rate you receive will be lower than personal loans or home equity loans.
You can use the money to make renovation to your home to increase the value, or to pay off high interest debt. However, there are some downsides to refinancing. Losing equity in your home in the biggest disadvantage of cash-out refinancing.
Get cash to make home improvements or repairs
The most common reason for getting a cash-out refinance is to make upgrades and improvements to a home, or to make costly repairs. Increasing the market value of a home is one of the smartest ways you can use the additional funds.
Extra cash you can add to your savings
If you’re low on savings, cashing out on your home equity can help you build up savings in the event of an emergency.
Use the funds to invest
With mortgage rates at all time lows it may not be a bad idea to take cash out of your mortgage and invest it. You can earn more in interest than you would pay in interest on a loan.
Pay off debt with high interest
For homeowners with a lot of high interest credit card debt can be challenging to pay off with all of the interest being charged each month. Paying off that debt with a low interest loan can help you get out pay off your credit cards and pay back the debt at a much lower rate.
Get a loan with a low mortgage rate
Personal loans or debt consolidation loans usually come with an interest much higher than cash-out refinancing loans. The rate you will receive will be in line with the current mortgage interest rates being offered on new mortgages.
Improve your credit score by paying off credit card debt
Your credit utilization ratio is the amount of available credit you’re using. For example if you have a total credit limit of $10,000 and you have a balance of $5,000 giving you a 50% utilization ratio, which is high.
Your credit utilization ratio accounts for 30% of your overall FICO score, only your payment history (35%) has a bigger impact on your score. By paying off your debt, your credit score could improve significantly.
Payments are tax deductible
The interest you pay on your mortgage payment is tax deductible. When you get a cash-out refinance you are getting a new mortgage for more than your previous balance, but it is all still considered a mortgage loan, thus you can write off the interest you pay.
Lose equity in your home
The obvious downside of cash-out refinancing is that you are reducing the amount of equity you have in your home. This is why you should be very careful with the funds you receive.
Funds are secured by your home
When you get a personal loan it’s unsecured. If you run into financial hardship and are unable to pay back the loan, besides bad credit not much else will happen. However, if you’re unable to make your mortgage payment you could face foreclosure.
Will increase your mortgage payment
Because you’re increasing the amount of your mortgage loan your monthly payment will be higher, even if you get a low rate. Take the higher payment into consideration when deciding whether or not to cash in your home equity.
Closing costs can be as high as purchasing
Closing costs and other lender fees will be added when you refinance your loan. On average closing costs are between 1%-3% of the total loan amount. Usually these costs can be rolled into the loan so you do not have to pay anything out of pocket.
Paying off unsecured credit card debt with secured debt is risky
Credit card debt is unsecured, if you cannot afford to make your payments you could be sued, have credit destroyed, but you won’t lose any of your assets.
If you get a cash-out refinance to pay off credit card debt you’re turning your unsecured debt into debt secured by your home. It’s a risky proposition that could back fire if you face financial issues.
You should also avoid falling back into the same trap of running up credit card debt because you could end up in the same position without the backup plan of a cash-out refinance because you cashed out your equity.
FHA Cash-out Refinance
Traditionally a cash-out refinance is available for conventional loans that are owned by Fannie Mae or Freddie Mac. However, borrowers who have an FHA loan or VA loan are in luck because the Government does have cash-out refinancing available as well. All of the same guidelines and requirements are similar to traditional cash-out loans.
Cash Out Requirements
In order to be eligible for a cash-out loan you’ll need to meet some basic requirements. Here are some of the guideline.
- Property must be owner-occupied – no investment properties
- Single family homes, 2-4 unit properties, and manufactured homes are eligible
- Borrower cannot have any late payments in the past 6 months
- No more than a single 30 day late mortgage payment in the past year
- Debt-to-income ratio of 36% or lower
- Maximum loan-to-value ratio limited to 80%
- Must have at least 70% LTV ratio to qualify
Cash out Refinance vs Home Equity Loans
A home equity loan, or home equity line of credit (HELOC) is similar to a cash-out refinance. However, instead of refinancing the mortgage and giving you extra cash to be repaid in one payment. A home equity loan is a second mortgage on a property and will be a separate payment from your mortgage.
Because a home equity loan is a second mortgage, qualify for one is more difficult that cash out refinancing.
Another type of refinance program is a streamline refinance. If you have a home loan that is backed by the Government, such as an FHA, VA, or USDA loan then you can use a streamline refinance. Like the name suggest, the process is streamlined requiring less documentation, making it easier and faster to refinance.
The bottom line
Cash-out refinancing makes perfect sense as long as you understand the risks and have a good plan for the money.
Making large repairs or renovations that increase the value of your home are intelligent ways to use the funds you receive.
Spending the money on a new car, vacation, or a new boat is not what you should be thinking about when getting a cash-out refinance.