Cash-out Refinancing

What is a cash-out refinance?

A cash-out refinance replaces your current home loan with a new mortgage for more than your outstanding loan balance. You withdraw the difference between the two mortgages in cash and put the money toward home remodeling, consolidating high-interest debt or other financial goals.

When you refinance a mortgage, you simply replace the existing loan with a new one for the same amount, usually at a lower interest rate or for a shorter loan term.

Cash-out refinancing, however, is different because you’re withdrawing a portion of your home equity in a lump sum. You’ll pay slightly higher interest rates for a cash-out refinance because you’re increasing the loan amount. Lenders limit the amount you can withdraw to no more than 80 percent of your home’s value to ensure you maintain an equity cushion.

Let’s look at an example of how cash-out refinancing works.

Say you still owe $100,000 on your home and it’s now worth $300,000. Let’s assume that refinancing your current mortgage means you can get a lower interest rate and you’ll use the cash to renovate your kitchen and bathrooms. Lenders generally require you to maintain at least 20 percent equity in your home after a cash-out refinance, so you’d be able to withdraw up to $140,000 in cash.

As of June 2019, 8.2 million homeowners could benefit from refinancing their current mortgage — 66 percent more than in May, according to the latest prepayment activity report from Black Knight.

There are many advantages to using a cash-out refinance over other types of loan products if you need a large sum of money. Here are some common reasons to use a cash-out refinance:

• Get a lower interest rate on their mortgage. This is the most common reason why most people do a traditional refinance, and it makes sense for cash-out refinancing, too, because you’ll be taking on a larger loan and lowering your interest costs.
• Make value-added home improvements or repairs to your home. Homeowners who use cash-out refis for these type of projects can deduct the mortgage interest from their taxes. Also, tapping your home’s equity could be less expensive than other forms of financing, such as a home equity loan, personal loan or credit cards.
• Consolidate and pay off high-interest debt. This move might make financial sense, but make sure the math checks out, says Greg McBride, CFA, Bankrate chief financial analyst. “Cash-out refinancing is beneficial if you can reduce the interest rate on your primary mortgage and make good use of the funds you take out,” he says.
• Help pay a child’s college tuition. If your adult child needs help paying for college, using your home’s equity to make up the shortfall can be a prudent move if student loan rates are much higher than what you can get with a cash-out refinance. If you have significant debt with double-digit interest rates, then it’s worth it to crunch the numbers to see if you come out better refinancing your house and paying off the debt that way.

Cash-out refinancing isn’t always the best move for every situation. Here are some reasons to avoid a cash-out refinance:

• Increases the interest rate of your existing mortgage. A general rule of thumb is to refinance to improve your financial situation and get a lower rate. If cash-out refinancing hikes your rate significantly, it may not be a wise move.
• Reestablishes private mortgage insurance, or PMI. Some lenders let you withdraw up to 90 percent of your home’s equity, but doing so might mean you must pay PMI again after you’ve canceled it. That can add to your overall borrowing costs in the long run over other types of financing.
• Drags out the repayment of an existing debt for decades. If you’re using a cash-out refinance to consolidate debt, make sure you’re not prolonging debt repayment over decades when you could have paid it off much sooner and at a lower total cost otherwise. “Keep in mind that the repayment on whatever cash you take out is being spread over 30 years, so paying off higher-cost credit card debt with a cash-out refinance may not yield the savings you’re thinking,” McBride says. “Using the cash out for home improvements is a more prudent use.”
• Heightens risk of losing your home. No matter how use you use a cash-out refinance, failing to repay the loan means you could wind up losing it to foreclosure. So don’t take out more cash than you absolutely need and ensure you’re using it for a purpose that will improve your finances instead of worsening your situation.
• Tempts you to use your home as a piggy bank. Tapping your home’s equity to pay for lavish vacations or purchases indicates a lack of discipline over your spending habits. It’s a place to live and not your personal ATM. If you’re struggling with getting your debt or spending habits under control, consider seeking help through a nonprofit credit counseling agency.

While lenders typically allow homeowners to borrow up to 80 percent of the home’s value, the threshold can vary, depending on your credit score and type of mortgage.

Lenders who offer loans insured by the Federal Housing Administration, or FHA, sometimes offer a cash-out refi option for FHA loans that allow you to borrow as much as 85 percent of the value of the home. In addition, cash-out refi loans guaranteed by the U.S. Department of Veterans Affairs are available for up to 100 percent of the home’s value.

Expect to pay about 3 percent to 6 percent of the new loan amount for closing costs to do a cash-out refinance. Your closing costs will include lender origination fees and an appraisal fee to assess the home’s current value. Shop around with multiple lenders to ensure you’re getting the most competitive rates and terms.

You might be able to roll the loan costs into your new mortgage to avoid up-front closing costs, but you’ll likely pay a higher interest rate. Plus, taking out another 30-year loan or refinancing at a higher interest rate might mean you pay more in total interest. Crunch the numbers to make sure the math works in your favor.

There are other options you should consider before you start comparing rates on a cash-out refi, including:

• Home equity line of credit, or HELOC
• Home equity loan
• Personal loan
• Reverse mortgage

A home equity line of credit or HELOC allows you to borrow money when you need to with a revolving line of credit, similar to a credit card. This can be useful if you need the money over a few years for a renovation project spread out over time. A HELOC interest rate is variable and changes with the prime rate.

A home equity loan is a second mortgage that gives you a lump sum amount and the interest rate is fixed, which helps homeowners budget for another monthly payment.

A reverse mortgage allows homeowners age 62 and up to withdraw cash from their homes and the balance does not have to be repaid as long as the borrower lives in the home and pays their property taxes and homeowners insurance.

Crunch the numbers carefully to ensure that a cash-out refinance is the right avenue for your financial needs. Remember that you’re putting your house on the line as collateral, which means you could lose it if you fail to repay the new mortgage. Tapping your home equity isn’t a decision to make lightly, but doing so can offer you a strategic way to improve your overall financial picture if done with care.