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When Should You Consider a Cash Out Refinance?Published | Editorial Disclosure
Ownership of your own home can be a potential goldmine waiting to be tapped when needed. Costs of home improvement or other major expenses can be conveniently taken care of by cashing out on your home’s equity, but not enough homeowners are aware of this opportunity.
One way to do this is by refinancing simply refers to a process of replacing or exchanging an existing mortgage for a new one. The key characteristic of the new mortgage is that it has more favorable terms and may end up saving you money.
Refinancing potentially allows you to negotiate a lower interest rate, reduce monthly mortgage payments, alter the total number of years for payback, or even access some cash, amongst other benefits.
There are two options when it comes to refinancing your mortgage:
- Refinancing an existing loan to alter the terms or negotiate for a reduced interest rate, known as a rate-and-term refinance.
- The second focuses on tapping into equity to get cash for personal expenses, referred to as a cash-out loan or cash-out refinance.
For the purpose of this article, our focal point would be the cash-out refinance.
What Is A Cash-Out Refinance? How Difficult Is It To Get One?
A cash-out refinance in simple terms is a mortgage refinancing option that exchanges an old mortgage for a new one, usually a larger amount than the existing loan. The main difference between this and the rate-and-term refinance option is that you get to keep some cash and use it however you’d like.
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Equity on a home increases as the mortgage matures and more of the loan is paid off. Therefore, equity refers to the portion of the mortgage that is paid off. However, there are two main ways by which equity increases:
- The first is by monthly mortgage payments that reduce the mortgage principal.
- The second is an increase in home base value.
A cash-out refinance simply considers the amount of equity that you have been able to build over time, and then you can leverage this to take out a larger mortgage. Basically, you’re able to borrow in excess of what you currently owe, so that you pay off your present debt and keep the remaining cash.
In this scenario, there is no need to make a second monthly payment as against when you take out a second mortgage. Instead, you just replace your old mortgage with the new one and continue with the monthly payments detailed in the terms.
A Detailed Example
Assume that you purchased a home for $250,000 and you’ve paid off $150,000. This implies that you have a $100,000 deficit leftover on your home. Say you need $30,000 to cover expenses like home renovations and some other personal business.
A cash-out refinance allows you to tap into a portion of your mortgage, and then add it to your new mortgage principal. In this scenario, your new mortgage principal would be the sum of the $100,000 owed on your previous mortgage plus your $30,000 cashout to make a total sum of $130,000.
After closing, your lender would give you the $30,000 in cash, and then you can use it as you please. Generally, cash-out refinances come with lower interest rates compared to credit cards.
How Difficult Is It and How Do I Choose a Lender?
While many homeowners consider this a popular method to quickly get large sums of cash, some often wonder how difficult it is to get a cash-out refi.
The key to making the most out of your cash-out refi is ensuring that you’ve selected the lender that offers you the best terms and rate. Research has proven that refinancing can save you up to thousands of dollars over the life of your mortgage loan, so choosing the right lender is important.
Straightforward comparison tools like Refily give homeowners the power to compare different estimated rates and terms that lenders have to offer, so they can ensure that they’re getting the absolute best deal. Before committing to any lender, make sure you’ve taken the time to use Refily in order to thoroughly compare all your different lender options. Click here if you’re curious to see which lender may offer you the best deal.
When Should You Consider One?
Cash-out refinancing provides a wide range of benefits as may even be preferable to taking out a second mortgage or a personal loan.
Before taking out a cash-out refinance the first factor to consider (as you should with any mortgage refinance), is whether it saves you any money.
Relative to its counterpart, the interest rate for a cash-out refi is slightly higher mainly because of the risk attached. It is considered a riskier loan because of the cash-out clause.
An impressive credit score and reasonable home equity that qualifies you for a cash-out refinance may be available, but it might not be the best move to make. You need to be certain that given your general financial situation, a cash-out refi is the next best move to get you where you want to go.
Even in the wake of an increase in your monthly mortgage payments, choosing cash-out refinancing can still make overall sense provided you’re reaping the benefits elsewhere.
Here are some reasons why you should consider cash-out refinancing:
- For Home Improvements and Renovations
This is one of the main reasons why people opt for a cash-out refinance.
First-party data points for consumers that are looking for a cash-out refinance vs. standard rate/term and then the % that are looking for cash out for a Home Improvement vs. other reasons:
|Month||People Requesting Cash Out|
|Month||Cash Out for Home Improvement|
It allows you to spend the equity you’ve earned over time on making your house even better. A new bathroom or kitchen here, fixing a broken HVAC system there, and you’re inadvertently raising the value of your home.
- To Consolidate Debt
With a cash-out refinance, you can clear your debts, and move what you owe to a lower-interest payment that is a lot more convenient.
Refinance rates are low at the moment, making it the perfect opportunity to consolidate accumulated high-interest consumer debt, provided your home has sufficient equity.
Auto loans and credit card balances typically have higher APRs relative to your mortgage. Therefore, paying them off with cash from your refinancing implies that you are consolidating these payments directly into your new mortgage payment.
- To Get a Lower Interest Rate
A high price purchase on a variable credit card would result in a significant amount of interest. In addition to paying this rate bound to the rate of federal funds set by the Federal Reserve, there are some percentage points thrown in the mix too.
Credit card interest rates are typically higher than refinance rates and using your equity to cover this saves you thousands in interest in the long run.
In addition to enjoying a lower rate on interest, you could save some money come tax season using a cash-out refinance. And unlike other loans, there’s a possibility of deducting some interest that you pay on your mortgage, effectively reducing the portion of your income that is taxed.
The amount that you would be able to save depends on your situation, but it’s nothing that a tax professional cannot handle.
- Funds for Investment
Instead of keeping your equity tied up in your home, freeing up some money to invest and earn compound interest may be a good call.
In the long run, you get to make enough profit to cover whatever interest you would have to pay on the loan. This is one great way of setting up a college fund for your kids or even building your retirement savings!
How Much Can You Get Out of a Cash-Out Refinance?
To accurately determine how much you can get from a cash-out refinance, you must know these three things:
- The value of your home
- Your mortgage balance (how much is left unpaid)
- Amount of retained equity that your lender requires you to have post refinancing
To determine the value of your home, lenders typically carry out a physical appraisal or make use of an automated valuation model — this model determines your home value based on the value of similar properties.
The lender then allows up to 80% or 90% of that amount, based on the rules set by the lender. The percentage leftover (10% or 20%) is retained equity, and you can’t borrow this portion.
Now that you know precisely the amount available to borrow, subtract what you have on your present mortgage from it, and this difference is what you get in cash.
Since it’s a loan and not income, it isn’t taxable from the point of view of the IRS. Also, you can decide to take just what you need if what the lender is offering is more. This way, you don’t have to pay interest on extra funds that you didn’t need.
If you’re wondering how much money you could potentially pull out from your home’s equity, Refily offers a calculator so that you could connect with a lender who could tell you what you might qualify for. Click here to get an idea of how much money you could get.
Upsides of a Cash-Out Refinance
- Allows you to borrow a significant amount of money at a relatively low-interest rate.
- Mortgage interest may be tax-deductible.
- Ranks among the cheapest ways to borrow money.
- An avenue for getting rid of high-interest debt, developing your property, and covering other expenses.
- The interest rate on the new mortgage may be significantly lower than your existing mortgage.
- Spending on home improvement can greatly increase the worth of your home.
- There are no restrictions on how you spend the money.
Downsides of a Cash-Out Refinance
- You might see an increase in the monthly mortgage payment sum.
- The timespan for paying off the mortgage might increase.
- Cashing out too much equity might require you to pay private mortgage insurance (PMI).
- A new mortgage might potentially come with a higher interest rate.
- In the long run, you might pay more mortgage interest.
- Closing costs can run into thousands of dollars.
The Bottom Line
A cash-out refinance can be an excellent way to put up to thousands of dollars into your pocket if you qualify. With the flexibility to spend that money however you’d like, homeowners typically go for this option when they need large sums of money to fund a large expense or pay off any debt.
Homeowners should always remember that the key to maximizing their cash-out refinance potential is to shop around for a lender that offers them the best terms and rates.
Lender comparison marketplaces like Refily make it incredibly easy for homeowners to select which lender could potentially give them the most money. If you’re ready to take advantage of low rates and want to refinance today, click here to start shopping around for the best lender that fits your needs.
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