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When Should You Consider a Cash Out Refinance?

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Atalokhai Ojeh

Atalokhai is a seasoned real estate and finance writer with over 4 years of experience under his belt...

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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 leveraging on your home’s equity. 

One way to do this is by refinancing. Refinancing in the real estate sphere 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. 

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? 

A cash-out refinance in plain 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. 

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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 relative to credit cards.  

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:

MonthPeople Requesting Cash Out
Jun 201946.13%
Jun 202159.46%
MonthCash Out for Home Improvement
Jun 201947.57%
Jun 202151.00%

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. 

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 amongst 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 Bottomline 

A cash-out refinance might be a great call particularly if you have the purpose of use all planned out. Despite the extra interest or payments that might accumulate, if the long-term benefits exceed these costs, then it just might make for a great call.

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