What Does a “Cash-Out Refinance” Mean?
You’ve probably heard the term “cash-out refinance” before. Maybe your neighbor used one to pay for their new deck or your sister took one out to cover your nephew’s first year of college tuition.
Whatever the reason, you know that cash-out refinances exist — and that they can help pay for things like home renovations, education costs, existing debt, and other unexpected expenses that might crop up.
How do they work, though? And are you eligible to use one yourself? Those questions you may be less clear on — and we’re here to help.
What is a Refinance?
Put simply, refinancing is closing out your old loan and replacing it with a new one.
It requires the same process you used when you initially purchased your home: you’ll choose a mortgage company (or use your old one), fill out a bunch of paperwork, show them your income and assets, and in the end, you’ll get a new loan, rate, and monthly payment.
What Does a “Cash Out” Refinance Mean?
A cash-out refinance is a type of mortgage refinancing option that allows homeowners to convert a portion of their home equity into cash.
It is an attractive option for homeowners who need significant cash for various purposes, such as debt consolidation, home improvement, or investment opportunities.
Why Would You Want to Refinance?
There are several reasons you might want to refinance.
Many people do it to lower their monthly mortgage payments, shorten the overall length of their loan (changing from a 30-year loan to a 10-year one, for example), consolidate their mortgage, credit cards, and other debts, or leverage their stake in the home for some extra cash flow.
You may also want to refinance if your current loan has an interest rate that fluctuates (called an adjustable-rate mortgage).
Typically, refinancing is a good move if:
- Current mortgage rates are lower than the rate you have on your current loan
- You have an adjustable-rate mortgage, and your rate is about to change
- You have several different kinds of debt you’d like to roll into one convenient monthly payment
- You need cash and want to use your home to get it
Cash-out Refinance Basics
At its simplest, a cash-out refinance is a new mortgage loan — just a bigger one than you have on your home currently.
Here’s how it works:
- You take out a new loan for a larger amount than your current balance. As a general example, say you have $50,000 remaining on your current mortgage. You might take out a $100,000 loan in a cash-out refinance.
- You’ll take the difference between those two loans in cash. In the above example, that’d be $50,000.
- Use those funds to cover whatever expenses you need — pay off debt, remodeling costs, tuition, medical bills, etc. There’s no limit to what you can spend your cash on.
- Continue paying off your new mortgage loan month after month, just as you were doing before. Keep in mind your payment may be slightly different than before, depending on the rates and terms offered by your lender.
Cash-out refinancing is usually best used when you’ve built up a good amount of equity in the home — meaning you’ve paid off some of your existing mortgage loan and you own a decent chunk of the property yourself. In the grand scheme of things, the more home you own, the more cash you can access via refinancing.
How does a Cash Out Refinance Work?
To get a cash-out refinance, homeowners apply for a new mortgage with their existing mortgage lender or a different lender. The amount of the new mortgage is higher than the existing mortgage, and the homeowner receives the difference in cash.
The new mortgage is subject to new terms and conditions, including a new interest rate and payment schedule.
To be eligible for a cash-out refinance, homeowners need to have sufficient equity in their home.
Most lenders require a minimum of 20% equity in the home to qualify. Additionally, homeowners need to have a good credit score, a stable income, and a low debt-to-income ratio.
The Application Process
The application process for a cash-out refinance is similar to a regular mortgage application.
Homeowners need to submit income and employment documentation, a credit report, and other financial information. The lender will also appraise the property to determine its current value.
How much Cash can be Obtained?
The amount of cash that can be obtained through a cash-out refinance depends on the homeowner’s equity and the lender’s maximum loan-to-value ratio. Most lenders allow homeowners to borrow up to 80% of their home’s value.
For example, if a home is worth $500,000, and the homeowner has $300,000 in equity, they can borrow up to $400,000 through a cash-out refinance.
When tapping the equity in your home might make sense
That said, tapping into your home equity is a big deal. It’s generally not recommended to refinance your home loan in order to fund non-essential expenses like a lavish vacation or a new car.
Still, there are a few occasions where borrowing against the equity you’ve built up in your home might make financial sense. In light of that, we have listed four of them for you below:
1. Covering education costs.
There’s no denying that getting a new degree is expensive. Whether you’re hoping to finance your child’s education costs or your own, a cash-out refinance might be a good way to do it.
In this case, while interest rates are still historically low, there’s a chance that you may be able to borrow the money you need for school at a much better interest rate than you would receive if you took out a student loan for the same amount.
2. Paying off high-interest debt.
Again, in general, the interest rates you’ll receive for mortgages are typically lower than those given for other financial products.
The caveat here is that it’s also important to look at the cause of the debt. One-time expenses, such as medical debts, are particularly good candidates for a cash-out refinance.
While credit card debt can be as well, in that case, it’s important to also take a look at your spending habits. A cash-out refinance will not be of as much benefit if you start accumulating new debt after you’ve paid off the original bills.
3. Financing home renovations.
Home renovations are another excellent reason to do a cash-out refinance. (Just make sure you choose the right projects if you go this route! Not all renovations are created equal.)
Here, you have the additional benefit of adding value to your home once the projects are completed, which may help replace some of the equity you’re borrowing against.
To that end, if you’ve been meaning to take on a larger home renovation project, such as a bathroom or kitchen remodel, a cash-out refinance may be a smart way to access the money you need.
4. Building your portfolio.
Lastly, if you are a real estate investor, you may be able to leverage your home’s equity to help you build a bigger real estate portfolio.
If you decide to take this route, you would use the excess proceeds from your cash-out refinance as the down payment on another investment property.
Alternatively, putting some of that cash into stocks, bonds, or other financial investments can also be a great way to ensure an ROI on your refinance. You might even consider investing in a rental or vacation property.
By finding a full-time tenant or listing the home on a short-term rental site (VRBO, Airbnb), you can add a consistent stream of income to your household.
5. Start an emergency fund.
If one hospital stay or major home repair could drain your savings, it’s probably wise to put some of your refinance cash toward an emergency fund.
This will help protect you in case something unexpected happens — and it will ensure you don’t have to open a high-interest credit account (or worse, have your newfound expense sent to collections when you can’t pay it).
Other Things to Know About Cash-Out Refinances
Refinances are processed just like your initial mortgage loan was. You’ll need to apply, prove your income and employment, provide various financial documentation, and have your credit report pulled.
All of these factors will influence the amount of money you can take out and the interest rate your new loan will come with.
Another important thing to keep in mind is that you don’t have to use your existing mortgage lender when refinancing. If you’re considering a cash-out refinance, make sure to evaluate all your options.
There may be a lender with better customer service, better rates, or better terms than your current lender offers.
Thinking of refinancing? Talk to a loan officer at Embrace Home Loans about what options may be available to you.
Is Refinancing Right for You?
It’s important to do the math before you decide whether to move forward with a refinance. Like with your first mortgage, refinancing will come with some costs. Closing costs on refinance loans typically range from 3 to 6 percent of the loan’s total, which could mean considerable costs on closing day.
Though refinancing to a lower rate may mean lowering your monthly payments, if you only have a few years left on the loan, you might not save enough to make the refinance worth it.
Take into account both the savings and costs of a refinance — and make sure you stand to come out on top.
Not sure if you should refinance your mortgage? An Embrace Home Loan officer can help. Contact us today to learn more.