If you’ve been following the real estate market at all, you’ve probably picked up on the fact that property values have been increasing in many locations around the country. The coronavirus pandemic led to a climate with low-interest rates, low inventory, and steadily rising prices.
For homeowners that didn’t sell their homes during this time, it means that they’ve likely gained equity in their houses due to rising real estate values. According to the Homeowner Equity Report from CoreLogic, the average homeowner gained about $33,400 in equity between 2020 and 2021.
On top of that, low mortgage rates have led a lot of Americans to consider refinancing their homes to lock in lower interest rates.
If you’re interested in refinancing your home and are hoping to borrow some cash, you might be able to do both at the same time with a cash-out refinance. However, there are a lot of different factors you will want to consider before applying. Let’s take a look at everything you need to know about cash-out refinances so you can make the best decision for your financial health.
What Is a Cash Out Refinance Loan?
When you own a home, you gain equity in the property as your mortgage picture. Equity is a term that refers to the amount of the property value that you have actually paid for. There are two different ways that homeowners can gain equity:
- The value of your home increases
- Through your monthly mortgage payments, you pay down your mortgage principal
The cash out refinance meaning refers to a particular kind of mortgage refinance. This refinance gives you cash in exchange for taking on a new, larger mortgage by taking advantage of the equity you have built over time. Basically, this is a way that you can borrow more than you out on your mortgage and take out the rest as a cash loan.
This is not the same thing as a second mortgage. When you take out a second mortgage, you are taking on another monthly payment. With a cash out refinance you replace your new mortgage and pay off your old mortgage at the same time.
Let’s take a look at an example. Say that you purchased a home for $300,000 and you have paid off $80,000. This means that you still owe $220,000 on the mortgage for your property. In addition, let’s say that you are interested in making $15,000 worth of home renovations.
When you get a cash out refinance, you are able to take out a portion of your equity. Then, the amount that you have taken out is added to the principal of your new mortgage.
In the example above, this would mean that your new mortgage is for $235,000. This number is reached by adding how much money you still owed on the home plus the amount of money that you are looking to borrow. A few days after closing, you receive the $15,000 that you are borrowing in cash.
The money that you take from your equity is yours to do anything you want with. You can cover unexpected auto or medical bills, catch up on your debt payments, or make repairs to the property. People will also use Cash Out refinances as a way to consolidate debt as they commonly have lower interest rates than most credit cards.
How Does a Cash Out Refinance Work?
If you are considering getting a cash out refinance, you might be wondering what the process is like. Ultimately, it is relatively similar to the process that you went through in order to purchase your property. The basic process consists of meeting the requirements, choosing a lender, applying, getting approval, and receiving your check.
Cash Out Finance Requirements
The requirements for qualifying for a refinance depend on the lender you are working with. However, there are some common requirements that can help give you a good idea of whether or not you might qualify.
The first is having a credit score of at least 620. If you are simply looking to refinance your mortgage, you typically need to have a credit score that is at least 580.
Your debt to income ratio is also an important factor. Commonly you will need to have a DTI that is less than 50%. Your DTI is calculated by taking your monthly payments and debts and dividing it by your monthly income.
Another factor is how much equity you have in your home. It is necessary to have built a sizable amount of equity if you’re interested in getting a cash out refinance. It’s important to know that, unless you qualify for a VA refinance, you won’t be able to take out 100% of your equity.
Figuring Out How Much Cash You Need
After you have determined that you will likely meet all of the requirements for a cash out refinance, it’s time to figure out how much money you want to borrow. If you are borrowing the money for renovations or repairs, you will want to get at least a couple of estimates from local contractors to give you a sense of how much money you will need.
If the reason you are refinancing is so that you can consolidate debt, you will want to take a look at your bank statements and credit cards to figure out precisely how much money you will need to transfer your debts.
Applying For a Cash Out Refinance Through a Lender
Now it is time to apply for a cash out refinance. As a part of this process, your lender might ask for a number of different financial documents. These might include pay stubs, bank statements, or W-2 in order to prove your debt to income ratio.
When you have received approval from your lender, they will be able to help walk you through the steps between here and closing. Once you’ve closed, you just have to wait for your check to arrive. This usually takes between three and five days.
How Much Cash Can You Take Out on a Cash Out Refinance?
The value of your home will play a role in how much money you can take out on a cash out refinance. You will need to have your home appraised before you can find out how much you qualify for. The rules of how much you can take out varies between lenders and can also be influenced by your particular circumstance.
In general, though, lenders will The amount you can borrow at 80% of the value of your home.
VA loans are the exception to this 80% rule. If you have a VA loan and are interested in a cash out refinance, you are allowed to take out the full amount of the equity you have in the home.
Cash Out Refinance Pros and Cons
Before you apply for a cash out refinance, you will want to think about both the advantages and drawbacks of borrowing money in this way. While it can be a smart financial decision for some people, for others it could end up being financially harmful.
Pro: Lower Interest Rates
One of the most obvious advantages of a cash out refinance versus other ways of borrowing money is that the interest-rate is typically quite low. In fact, the interest-rate for a cash out refinance is usually lower than a home equity loan or a home equity line of credit (HELOC).
This can make sense if you are looking to borrow money and are interested in refinancing to lower rates than when you buy your home. For example, if you thought your property around the year 2000, their interest rate might be around 9%. The interest rate today is quite a bit lower and refinancing can help you take advantage of that.
Pro: Higher Credit Score
If you are taking out a cash out refinance to pay off your credit card debt and other debt, this can help you build your credit score. This is because your credit utilization ratio will be reduced. This is a ratio that displays the percentage of credit that you have available to you.
There are a number of advantages to having a higher credit score. Having good to excellent credit can help you save a lot of money on interest in the years to come and can help you lock down better loan terms in the future.
(Are you curious about what the lending options are for physicians? Take a look at this post.)
Pro: Tax Deductions
If you use the money you borrow to build, buy, or substantially improve your home, you might be able to use the mortgage interest deduction when tax time rolls around. This is a tax deduction that you can claim for the mortgage interest you paid on the first one million dollars of home loan debt. In order to take advantage of this deduction, your tax returns will need to be itemized.
Pro: Debt Consolidation
If you have high-interest credit card debt, the money from a cash out refinance you pay it off could end up saving you multiple thousands of dollars in interest. However, you will want to be careful taking out money to consolidate your debt if your debt resulted from having unhealthy spending habits. Otherwise, you could find yourself simply racking up even more debt on top of what you already have.
Con: New Terms
One of the negative aspects of a cash out refinance is that the terms of your new mortgage will be different than your previous mortgage. This is not necessarily a bad thing. However, you’ll want to double-check your fees and your interest rate before you agree to taking out a cash out refinance.
(Are you looking to get a mortgage in Colorado? If so, check out our guide here.)
Con: Foreclosure Risk
Another downside of a cash out refinance is that your home is the collateral for the loan, as it is for any type of mortgage. That means that if you are unable to make the monthly payments, you risk losing your home.
While some people might choose to pay off credit card debt with a cash out refinance, there is some reason to be concerned about. Basically, you are paying off unsecured debt using secured debt. This means that you are paying off debt that isn’t backed by collateral with debt that is, leaving you exposed to the risk of losing your home if you are unable to pay it back.
Con: Private Mortgage Insurance
You’ll have to pay for private mortgage insurance if you borrow more than 80% of the value of your home. For example, if your home is valued at $400,000 and you refinance for more than $320,000, you are most likely going to have to pay private mortgage insurance. This typically costs between .55% to 2.25% of the total loan amount every year.
As an example, private mortgage insurance of 1% on a $200,000 mortgage would cost you $2000 every year.
Con: Cash Out Refinance Closing Costs
With any kind of refinance you end up paying closing costs. These usually amount to somewhere between 2% and 5% of your mortgage. This means that you will need to run the math and make sure that the amount of money you are saving is worth the amount of money you are spending.
For example, if your loan is for $300,000, the closing costs will be between $6000 and $25,000. You will want to make sure that you are saving more than that by going this route when you borrow money, otherwise, another avenue might serve you better.
Is a cash out refinance a good idea? The answer to that question isn’t going to be the same for everyone, so you’ll want to take a look at your finances and your needs before applying.
Con: Enabling Bad Spending Habits
Lastly, taking out money from your equity in this way can end up backfiring if you are not careful. For example, if you use your cash-out refinance to pay off your credit card debt, you will be left with a bunch of empty credit card balances. If bad spending habits got you into debt in the first place, you’ll want to be very certain that you aren’t just going to end up digging yourself deeper into debt with your cash out refinance.
(Are you looking to buy a house in the U.S. as an ex-pat? Check out this article to learn more.)
Can You Take Out a Cash Out Refinance to Buy a Second Home?
For many people, getting a second home is a major goal. Whether you want this property as an investment property, a vacation home, or a dream retirement home, the cash out refinance can help you get the money that you need in order to afford the down payment.
At the same time, you might find that you will also be able to lower the interest rate of your current home mortgage loan.
However, if you want more flexible repayment terms or you don’t qualify for lower mortgage rates, a cash out refinance might not be the best way to fund your second home. Some other options include:
- Home equity loan
- Home equity line of credit (HELOC)
If you’re looking to take out a cash out refinance to fund an investment property, the process is exactly the same as if you were using the money for another purpose.
Both of these methods of borrowing money come with their own pros and cons. Depending on your specific financial situation, you might find that one of these options is more suitable to your needs.
What Can You Use the Cash For?
When you take out money from the equity you have in your home through a cash out refinance, you can use the money in any way that you please. However, there are a number of common purposes that people pursue a cash out refinance.
Home Improvement Projects
If you are looking to fund a home improvement project at your house, you might end up increasing the value of your home. If this is the case, you can deduct the mortgage interest from your taxes.
Some people might access this capital in order to purchase an investment property or build their retirement savings. You’ll want to run the math on whether or not the money will be working more for you in the form of equity or elsewhere.
Child’s College Education
The tuition at American colleges seems to be steadily increasing every single year. If you’re determined to pay for your child’s education, you can tap into your home equity to help foot the bill. This is a popular option because the interest rates are usually quite a bit lower than the rates for student loans.
Consolidate High-Interest Debt
Compared to other forms of debt, such as credit cards, refinance rates tend to be quite low. Many people choose to consolidate their debt by getting a cash out refinance, saving them thousands of dollars on interest over time. This can also make paying back debt much simpler, as you now only have one monthly payment for all of the debt that you owe.
Cash Out Refinance Vs HELOC
Cash out refinances and HELOCs are both ways that you can borrow against your home’s available equity. There are a number of key differences between these two options.
When you take out a cash out refinance, the terms of your new mortgage might be different than those of your previous mortgage. This means that you’ll have a new payment amortization schedule.
With a HELOC, on the other hand, you’re usually just taking out money that is in addition to your existing mortgage. Since this is considered a second mortgage, the HELOC will have its own repayment schedule and term separate from your original mortgage.
How the Funds Are Received
When you get a cash out refinance, you receive a lump sum after the closing. The proceeds from the loan first go to pay off your existing mortgage, prepaid items, and closing costs. The rest of the money goes in your pocket.
With a HELOC, you can withdraw money as you need it from an available line of credit. There is a draw period attached to HELOCs which is commonly ten years.
You can use either a fixed-rate mortgage or an adjustable-rate mortgage when you take out a cash-out refinance. For HELOCs, the interest rate changes in conjunction with an index. This means that your interest rate will decrease or increase depending on what happens with the index.
When you get a cash out refinance, the closing costs are very similar to those you paid when you first got a mortgage. When you get a HELOC, on the other hand, the closing costs are usually relatively small if there are any at all.
As you can see, there are some very important differences between these two types of loans. Depending on your needs and circumstances, one might make more sense than the other.
Is It Time For You to Refinance Your Home?
As you can see, there are a lot of compelling reasons to get a cash out refinance on your home. However, not all homeowners will be eligible and others might find that it’s not the proper avenue for borrowing given their specific circumstances. Refinancing is a decision that you will want to make after weighing out the pros and cons and how they apply to your financial situation and needs.
Are you interested in refinancing your existing home loan in Denver? If so, you can learn more about refinancing through Fairway Fast Mortgage today!