Cash-Out Refinance In Real Estate:
Your Ultimate Guide
One of the most significant investments you'll make is buying a home, so it's important to make sure it's comfortable and up-to-date. Nevertheless, building up the necessary savings for home renovations and repairs can be challenging.
Cash-out refinancing may be the answer for you. Rather than using credit cards, a personal loan, or a second mortgage, you can utilize them to accomplish your home improvement goals. Using a cash-out refinance can also help you cover repair bills, consolidate debt or even pay off your student loans by using the money you've already paid into your mortgage.
In this article, we will discuss the ins and outs of cash-out refinancing so you can decide if it's for you.
What Is A Cash-Out Refinance?
Cash-out refinances allow you to convert home equity into cash. You take out a new mortgage for more than your previous mortgage balance and receive the difference in cash.
Generally, refinancing refers to replacing an existing mortgage with a new one with more favorable terms for the borrower. The benefits of refinancing a mortgage include reducing monthly payments, negotiating a lower interest rate, renegotiating the periodic loan terms, removing or adding borrowers from your loan obligation, and accessing the equity from your home when you refinance with cash.
How Cash-Out Refinances Work
With a cash-out refinance, you can use your home as collateral to secure a new loan, along with some cash, which creates a larger mortgage than what is currently owed. Your home equity can be a great source of funds for emergencies, expenses, and wants.
Borrowers interested in cash-out refinances find lenders willing to work with them. Lenders evaluate the borrower's credit profile, current mortgage terms, and the balance needed to pay off the loan. Based on the underwriting analysis, the lender makes an offer. Upon receiving a new loan, the borrower pays off their old one and locks them into a new monthly payment plan. An additional cash payment is made above and beyond the mortgage payoff.
In a standard refinance, the borrower does not receive any cash, just lower monthly payments. As a general rule, cash-out refinance funds can be used as the borrower sees fit. However, many use the money to settle huge expenses, such as consolidating debt, covering medical bills, or using it as an emergency fund.
With a cash-out refinance, your house has less equity, which means the lender takes on greater risk. Therefore, closing costs, fees, or interest rates may be higher than in a standard refinance. It is often possible for borrowers with specialty mortgages, such as U.S. Department of Veterans Affairs (VA) loans, to refinance with more favorable terms and lower fees than non-VA loans.
Example Of A Cash-Out Refinance
Consider buying a property worth $300,000 with a $200,000 mortgage and still owing $100,000 after many years. If the property value has not fallen below $300,000, you have also built up at least $200,000 in home equity. The underwriting process could allow you to borrow up to 80% of your home equity if rates are low and you are refinancing.
Many people may not be willing to take on another $200,000 loan, but having equity can boost your cash flow. Assume that your lender will lend you 75% of the value of your home. In the case of a $300,000 home, this would be $225,000. The remaining principal must be paid off with $100,000, and you are left with $125,000 in cash.
If you only want $50,000 in cash, you would refinance with a $150,000 mortgage loan with a lower interest rate and new terms. As part of the new mortgage, there would be the $100,000 remaining balance from the original loan plus $50,000 taken out in cash.
Essentially, you can assume a $150,000 mortgage, get $50,000 in cash, and begin making monthly payments for the full amount. This is one of the advantages of collateralized loans. The disadvantage is that since the $100,000 and $50,000 are combined into one loan, the new lien on your home will apply to both.
How To Prepare For A Cash-Out Refinance
You can prepare for a cash-out refinance by following these steps.
1. Check the lender's minimum requirements.
For cash-out refinancing, mortgage lenders have different requirements, and most require a minimum credit score of 620 - the higher, the better - although some will accept scores as low as 580. Additionally, a debt-to-income ratio below 43 percent (or 50 percent in some cases) and home equity of at least 20 percent are usually required. Take note of the requirements as you explore your options.
2. Figure out the amount of cash you need.
You likely need funds for a specific purpose if you're considering a cash-out refinance. If you don’t know what that is, figuring that out can help you borrow only what you need. If you plan to use the cash to consolidate debt, gather your personal loan and credit card statements, and add up your debt obligations. Consult with a few contractors to get an estimate of labor and materials before spending the money on renovations.
3. Prepare your cash out-refinancing application.
Prepare all of your financial information related to your income, assets, and debt for the application once you've shopped around for lenders to get the best rate and terms. You may need to submit additional documentation as the lender evaluates your application.
When is the best time to get a cash-out refinance?
According to Greg McBride, CFA, Bankrate's chief financial analyst, if you can reduce the interest rate on your primary mortgage and use the funds effectively, cash-out refinancing can be beneficial. Given the current economic climate, it's unlikely you'll receive a lower interest rate unless rates were on the higher end when you took out your current mortgage and your credit score has improved significantly. Despite this, a cash-out refinance may be advantageous if the funds will improve your home's value and if it's less expensive than a high-interest credit card.
Cash-out Refinances: Pros and Cons
As interest rates fall toward new lows, savvy investors tend to refinance as soon as the opportunity arises. Refinancing can come in various forms, but all will come with additional costs and fees, making the timing of refinancing as important as whether or not to refinance.
In addition to comparing rates and fees, consider your reasons for needing cash before refinancing. The interest rates on this refinancing option tend to be lower than those on unsecured debt, such as credit cards or personal loans. However, you can lose your home if you can't pay your mortgage, for instance, or if the value of your home decreases and you end up underwater on your mortgage.
You should carefully consider if the cash you need is worth the risk of losing your home if you cannot make payments. To avoid getting caught in an endless cycle of debt reloading, control your spending so you can pay off consumer debt. Consumer Financial Protection Bureau (CFPB) offers several excellent guides to assist you in determining whether a refinance is right for you.
Cash-out refinancing offers borrowers all the benefits they would expect from a standard refinance, including lower rates and other benefits. Moreover, borrowers can use the cash to pay down other high-rate debt or fund a large purchase. If rates are low or during times of crisis, like in 2020–21 following global lockdowns and quarantines, lower payments and extra cash can be very beneficial.
Is A Cash-Out Refinance Right For You?
Many people can benefit from cash-out refinancing.
Mortgage rates are rising. However, since lenders take on relatively minimal risk with a cash-out refinance - your home - they can keep refinancing rates low.
Therefore, cash-out refinancing is the cheapest way to pay for large expenses. Homeowners usually use the proceeds for the following reasons:
- Home improvement projects: If homeowners use the funds from a cash-out refinance to improve their homes, they can deduct mortgage interest from their taxes.
- Investment purposes: Homeowners can use cash-out refinances to build retirement savings or purchase investment properties.
- High-interest debt consolidation: Compared to other forms of debt, like credit cards, refinance rates are typically lower. A cash-out refinance allows you to pay off these debts and repay the loan with one, lower-cost monthly payment.
- Child’s college education: If the refinance rate is lower than the student loan rate, tapping into home equity can make sense to pay for education.
How Much Can You Get On A Cash-Out Refinance?
Typically, the amount you earn on your refinance depends on the value of your home. To determine how much you qualify for, you will need to have your home appraised. Lenders generally allow you to borrow no more than 80% of your home's value, but it may vary from lender to lender. VA loans are an exception to the 80% rule, as they allow you to borrow up to the full amount of your equity.
How Do Cash-Out Refinances And Home Equity Loans Differ?
There are some major differences between a cash-out refinance and a home equity loan that allows borrowers to tap the equity in their homes. Cash-out refinancing involves taking out a new loan for a higher amount, paying off the existing one, and receiving the difference in cash. By contrast, a home equity loan is a second mortgage - it does not replace your first mortgage - and can sometimes come with a higher interest rate.
Is There A Fee Associated With A Cash-Out Refinance?
In a cash-out refinance, you can expect to pay about 3 to 5 percent of the new loan amount in closing costs. In addition to lender origination fees, these closing costs can include appraisal fees to determine the home's current value. Make sure you shop with multiple lenders to get the best rates and terms. In some cases, you can roll loan costs into your new mortgage to avoid upfront closing costs, but you'll probably pay a higher interest rate. A 30-year loan or refinancing at a higher rate could mean you pay more interest throughout the loan.
What are alternatives to cash-out refinancing?
Consider these other options in addition to a home equity loan:
HELOC: Similar to a credit card, a home equity line of credit (HELOC) allows you to borrow money when you need it with a revolving line of credit. It can be useful if you need money for a few years for a renovation project. Rates on HELOCs are variable and change with prime rates.
Personal loan: A personal loan is a short-term loan that can be used for almost any purpose. Interest rates on personal loans vary widely and can depend on your credit score, but you usually repay the loan with a monthly payment, similar to a mortgage.
Reverse mortgage: Homeowners aged 62 and over can withdraw cash from their homes with a reverse mortgage. The balance does not have to be repaid as long as the borrower pays their property taxes and homeowners insurance.
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