A cash-out refinance loan allows you to borrow against your home equity to pursue other financial goals.
A cash-out refinance loan, also known as a cash-out refi, allows you to take out a new mortgage loan and borrow cash against your home equity.
In addition to receiving cash from the new loan, you may also be able to lower your interest rate, add or remove borrowers from the loan, or change your repayment period.
As with all tools, there’s a right and wrong way to use them — plus lots of gray areas in between. This guide will help you understand what a cash-out refinance is and strategic ways to use it.
How Does a Cash-out Refinance Work?
When you take out a cash-out refinance loan, you take out a new loan that replaces your current mortgage. The new loan effectively pays off the previous mortgage, and your new balance includes whatever you owed on the old loan plus any amount you borrow in cash.
Let’s assume your home is worth $300,000. You owe $100,000 on your existing mortgage, so you have $200,000 in home equity.
In most cases, you can borrow up to 80% of your home equity in a cash-out refinance loan. If you are an eligible VA borrower, you may qualify for a 100% VA cash-out refinance loan. But most borrowers on most loan types will be capped at 80% of their home equity.
If you have $200,000 in equity in a $300,000 house, you may be able to take out a cash-out refinance loan for $240,000. This includes $100,000 to pay off your current mortgage plus up to 80% of your equity (which equals $140,000).
How much you can borrow depends on the value of your home and how much of your mortgage you’ve already paid down. Your lender will likely need to order an appraisal of your home to determine its current market value.
As with your original mortgage, you will pay closing costs and fees on a cash-out refinance loan.
How do you qualify for a cash-out refinance loan?
To qualify for a cash-out refinance loan, you will need to meet the following requirements:
- Credit score of 620 or higher (for a conventional cash-out refinance loan)
- Debt-to-income ratio* (DTI) of 45% or less
- 20-50% equity in the home
If you’re considering a cash-out refinance, a loan officer can guide you through the requirements and explain exactly how much you qualify for and can borrow against your home.
How can you use the money you receive from a cash-out refinance loan?
You can use the funds from a cash-out refinance however you choose.
“Cash-out refinances can save a homeowner a ton of money per month when they are used to consolidate high interest debt, like credit cards and/or personal loans,” says Chris Gonzalez, a Fairway loan officer in Freeport, New York. “They can also be used to source the funds to buy an investment property which can elevate monthly cash flow. Owning an investment property is also a great way to create future wealth by leveraging the primary home to take advantage of appreciation in two homes instead of just one. Cash-out refinances can also be used to renovate and upgrade your home.”
A key advantage of using a cash-out refinance for big expenses: “From a monthly payment perspective, they are the cheapest way to get money out there,” Gonzalez says. “The increase to the payment is always lower than what a fixed second mortgage will be and a better option than a HELOC long term.”
Remember, though, that you are borrowing against your home and that taking out a cash-out refinance could mean higher payments or a longer repayment period on the new loan. It’s wise to think carefully about how you’re using the funds, as you may want to only use the money toward other big picture financial goals.
Making long overdue upgrades to the home could increase the value of the property. Consolidating high-interest debt can help you save money and potentially improve your credit score. Making a down payment on a second house can help you grow your wealth through that
property’s equity. Paying for your children’s education may establish a strong financial foundation for their future.
But using the money for things like taking a vacation, buying a new car, or making non-urgent cosmetic upgrades to your home could end up causing you financial strain. If the payments on the loan become challenging due to job loss or illness, you may be jeopardizing your house for non-essential expenses.
What are the disadvantages of a cash-out refinance?
A cash-out refinance comes with fees and closing costs that eat into the total amount you receive from the loan.
Refinancing can lengthen your repayment period on the home, so you may pay more for the property over time.
If interest rates have increased since you took out your first mortgage, you may pay a higher rate, further increasing your costs for the home over time.
Pros and cons of a cash-out refinance loan
- Borrow cash against your home equity
- Use the cash however you choose, including for renovations, college tuition, a down payment on another property, or to consolidate high-interest debt
- You may qualify for a lower interest rate, depending on the current market and your finances
- Opportunity to extend the repayment period on the loan
- Increase the amount you owe on your home
- Extending the repayment period may mean paying more for the home over time, especially if interest rates have increased
- Pay closing costs and fees on the loan
- Temptation to borrow against your home for non-essential expenses, such as vacations and cosmetic renovations to the property
The bottom line on cash-out refinances
A cash-out refinance can be a great source of extra funds and a way to accomplish financial goals. However, it’s a double-edged sword that can be a great help or great harm if not used properly.
Only consider a cash-out refinance loan when you have a definite plan for the additional funds. Ideally, you’ll use this loan to improve your finances and build long-term wealth.
*Debt-to-income (DTI) ratio is monthly debt/expenses divided by gross monthly income.
The information in this advertisement does not constitute financial planning advice. Please consult a financial planner regarding your specific situation.
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