A cash-out refinance can help you access funding to meet your financial goals faster. It’s a type of mortgage that lets you convert your home equity into cash without taking out a second loan. This home loan product has several benefits and drawbacks worth considering before deciding if it’s ideal for your financial situation.
Here’s everything you need to know about cash-out refinances, from how they work to the pros and cons, borrowing costs and how to qualify for a loan.
Introduction to Cash-Out Refinance
Below diving too deep into the specifics, it’s vital to understand the basics of cash-out refinances.
What is a Cash-Out Refinance?
A cash-out refinance involves replacing your current mortgage with a new one larger than what you currently owe. The difference is the amount you pull out in home equity, and the money can be used however you see fit.
How Does a Cash-Out Refinance Work?
When you apply for a cash-out refinance, the mortgage lender gets your home appraised to determine its value. During the review process, the lender also evaluates your finances and creditworthiness to decide how big of a loan they can offer you.
If approved, you will go through the closing process like when you took out your current loan. Once the new loan closes, the lender will pay off your old mortgage and disburse the remaining funds to you.
You’ll begin repaying your new loan per the agreed-upon terms. The monthly payment will typically be higher, and you can expect a different interest rate and, in some instances, a different loan term.
Cash-Out Refinance Example: How Much Can You Get
To illustrate how this type of mortgage works, assume your home is worth $400,000 and you owe $250,000. If a lender approves you to pull out 80 percent in home equity, you would receive $70,000 in cash, and your new loan amount would be $320,000.
The $45,000 you pull out is computed by:
- Multiplying your home’s value by 80 percent.: $400,000 * .80 = $320,000
- Subtracting your current mortgage balance from this figure: $320,000 – $250,000 = $70,000
You can calculate the new loan balance by adding the cash you pull out to the amount you owe on the home ($70,000 + $250,000 = $320,000)
How Does a Cash-Out Refinance Differ from Other Types of Refinance?
The other most common type of refinance is a rate-and-term refinance, which focuses on making your mortgage payments more affordable or paying your loan off faster. It adjusts your mortgage rate, term or both but doesn’t extract equity from your home.
What Can You Use a Cash-Out Refinance For?
There are no spending restrictions on the funds you receive through a cash-out refinance. That said, homeowners commonly use the funds to consolidate high-interest debt (i.e., credit cards) or to cover the cost of home improvement or repair projects. You can also use the loan proceeds to establish an emergency fund, pay for higher education expenses, start a business or cover other big-ticket expenses.
Advantages and Disadvantages of Cash-Out Refinancing
Let’s review some of the cash-out refinance pros and cons to ensure you can make an informed decision:
Advantages:
- Flexibility: Cash-out refinancing lets homeowners access their home equity and use the funds for various purposes, such as home improvements, debt consolidation or other pressing financial needs.
- Better rates: Often, the interest rates on a cash-out refinance can be lower than the rates you would pay on other types of loans, such as personal loans or credit cards.
- Lower borrowing costs: A cash-out refinance may offer lower overall borrowing costs than other financing forms due to the potentially lower interest rates.
Disadvantages:
- Steeper loan amount: A cash-out refinance increases the amount you owe on your mortgage, giving you a more significant debt load to manage.
- Closing costs: They can cost you thousands of dollars and should be considered before applying for a cash-out refinance.
- More interest costs: Over the life of the loan, you may end up paying more in interest costs due to the more considerable loan amount, especially if you do not secure a significantly lower interest rate or if you extend the term of your mortgage
Is a Cash Out Refinance Worth It?
A cash-out refinance can provide much-needed funds to cover expenses or meet financial goals. However, it’s not without potential drawbacks that could make the costs outweigh the benefits.
You’ll need to compare the new rate with what you currently have. It’s equally important to consider how the new loan term would impact the total interest paid and factor in the closing costs associated with a cash-out refinance.
Doing so lets you run the numbers to decide if a cash-out refinance is worthwhile.
How Do You Qualify for a Cash-Out Refinance?
If you’re leaning towards this option, here’s what you’ll generally need to qualify.
Home Equity
As previously mentioned, home equity is the difference between your home’s value and what you currently owe on the mortgage. Most lenders require you to have at least 20 percent in equity after the cash-out refinance, which means you can access up to 80 percent of the amount you own outright.
Credit Score
A credit score of 660 or higher gives you the best chance of getting approved for a cash-out refinance with favorable terms. That’s not to say a lower credit score automatically disqualifies you for financing. Still, it could limit your options and make finding a reasonable loan a bit more challenging.
LTV Ratio
Your loan-to-value (LTV) ratio is calculated by dividing how much you owe by what your home is worth and multiplying the result by 100 to make it a percentage. Lenders typically cap the LTV at 80 percent.
Debt-to-income Ratio
Your debt-to-income ratio (DTI) divides your monthly debt payments by your gross income. Lenders use this to determine if you can manage monthly payments after the refinance. A DTI ratio under 43 percent is preferred, though this may vary by lender.
Income and Employment Verification
Stable income and employment history reassure lenders of your ability to repay the new loan. You’ll likely need to provide recent pay stubs, tax returns or other documentation to verify you have a consistent stream of income.
Home Appraisal
A home appraisal is typically required to assess the current value of your home. The appraised value will directly impact the amount you can borrow through a cash-out refinance. A higher home value can boost your approval odds and potentially grant you access to more funds.
How Much Does a Cash-Out Refinance Cost?
Closing costs should be considered, typically between 2 percent and 6 percent of the loan amount. They can increase your balance if you roll them into the new loan.
If you don’t have at least 20 percent equity left in your home after the cash-out, the lender may approve you but require private mortgage insurance. These premiums will increase your monthly mortgage payments.
The Process of Cash-Out Refinancing
Applying for a cash-out refinance entails the following:
Assess How Much You Need
Begin by calculating the amount of cash you need. This step is critical because it will influence the size of your new refinance loan and the amount of equity you’ll keep in your home. Plus, you only want to borrow what you actually need to avoid an excessive monthly mortgage payment and added interest costs over the loan term.
Check Your Eligibility
Your mortgage lender will consider several factors to determine your eligibility for a cash-out refinance. These include your credit score, current mortgage payment history and DTI. You must meet the lender’s requirements to qualify for a loan, preferably with favorable terms.
Prepare All the Requirements and Submit Your Application
Gather all necessary financial documents, including recent pay stubs, bank statements and tax returns. Also, be sure to complete the loan application and review it before submitting it to the lender to ensure it’s free of errors. Otherwise, you could face delays in the lending process.
Home Appraisal and Underwriting
A licensed, professional home appraiser conducts a home appraisal to assess the current value of your property. This step is vital, as it determines how much equity you can access. Upon completion, the underwriter evaluates all your provided information and the appraisal to determine the new loan amount and clear the loan for closing.
Closing
During the closing, you’ll finalize the new mortgage terms and receive the cash from your cash-out refinance. Be prepared to pay closing costs, including appraisal fees, title searches, and other related expenses. After closing, the lender disburses funds in a lump sum payment.
How to Choose a Lender Offering Cash-Out Refinancing
There’s no shortage of lenders offering cash-out refinances, and a quick search could yield what looks like the perfect fit. Still, it’s vital to do your research to increase the chances of finding a reputable lender that offers competitive terms for your financial situation.
And don’t just look at the interest rates. Evaluate origination fees, appraisal fees and closing costs. Also, consider the lender’s repayment terms and ask if they offer prepayment penalties. Most importantly, read reviews to get a feel for the lender’s reputation and if they’re perceived positively by past and current borrowers.
