If you need money for an unexpected expense or to help pay off debt, you may consider taking out a loan. But if you own a home, a cash-out refinance may allow you to use the value already in your home to help you reach your financial goals. But before you start exploring a cash-out refinance, you should be aware of a few risks.
We’ll explore the pros and cons of cash-out refinance, but first let’s get a solid understanding of what a cash-out refinance is and why someone might consider this option.
What is a cash-out refinance?
With any sort of a mortgage refinance (or “refi”), your current mortgage is replaced with a new one. Traditional “rate-and-term” refi allows you to borrow about the same amount that you currently owe on your mortgage. This can often help you get a lower interest rate and/or better terms on the remainder you still owe, which could help you to save money and pay less on your mortgage over time.
A cash-out refi is similar, but you borrow more than you currently owe and keep the remaining dollar difference as cash you can use however you want: to make home renovations, pay off debts, or fund a large expense. The amount you can borrow with a cash-out refi is based not on what you currently owe on the mortgage, but rather on your home’s equity.
Equity is the cash value of your home that exceeds what you currently owe. Let’s say your home is worth $250,000 and you still owe $100,000 on your current mortgage. That means that the equity in your home—or the value that exceeds the amount owed—would be $150,000.
Cash-out refi lenders will use what is called a loan-to-value (LTV) ratio to help determine your creditworthiness, which is calculated by comparing the value of your home with how much you mean to borrow. Cash-out refi lenders will usually grant you up to 80 percent of your home’s total LTV ratio. So, using the above example, you could borrow up to $200,000 (or 80 percent of $250,000), put $100,000 toward your mortgage, and keep the remaining $100,000 as cash.
Why would you do a cash-out refi?
Cash-out refinancing provides you with a large lump sum of cash that you can spend in any way you like. Sounds tempting, right? But given the pros and cons of cash-out finance, most experts will encourage you to use that cash only for sensible reasons such as re-investing in home equity or paying off major expenses and debts. There are many reasons to consider a cash-out refi, such as the following.
Pay for home repairs
The most typical (and practical) purpose for cash-out refinancing is to help pay for home improvements. Home renovations, expansions, or critical maintenance all help to increase the value of your home—a reinvestment back into your home equity and your financial future.
It’s worth keeping in mind, though, that a cash-out refi is not a good option if you’re thinking about paying for emergency repairs, like a leak or a collapsing roof, since the refinancing process could take up to several months.
Cover a major expense
Home improvements are not the only good reason to choose a cash-out refi. Major necessary or unexpected expenses can also be legitimate incentives to opt for cash-out refinancing.
For instance, if you have a child enrolling in college and you haven’t yet figured out how to pay for it, cash-out refinancing may be a better option than student loans, since the interest rate on student loans could be much higher. Keep in mind, though, that you’ll be putting your home up as an asset in order to float your child’s education. So if you fail to pay off this new mortgage, you’ll be risking the loss of your home.
Cash-out refinancing can also be used to help consolidate your debt. If you have several high-interest rate credit cards, using the cash from refinancing to pay those off will give you fewer individual accounts to worry about. You’ll still have to find a way to pay off the debt, of course, but now it will be combined with your mortgage into a single convenient monthly payment.
A mortgage is a secured loan, which generally carries a lower interest rate than a credit card. However, a secured loan also means that you could lose your assets—in this case, your home—if you don’t keep up with monthly payments.
The pros of cash-out refinance
Should you do a cash-out refi? There are many benefits to consider, including lower interest rates (if you bought your home when rates were higher), cash for paying off high-interest loans and credit cards, and additional time for paying off high-interest debt.
If you apply the cash from your refi toward paying off high-interest loans and credit cards, you could save money since the interest rate on a cash-out refi is lower than that associated with credit cards. A cash-out refi may also give you more time to pay the debt back, which could relieve some financial pressure.
Using a cash-out refinance to pay off those high-interest accounts could also improve your credit score, but if you fail to repay on the refinance, you could be at risk of losing your home and your credit could take a plunge.
Since mortgage interest is tax deductible, a cash-out refi could provide you with a larger tax refund in addition to helping you lower your taxable income. And since cash-out refinancing lets you borrow money at a low cost, using it to get cash for renovations, college tuition for your kids, or any other major expense could be better than taking out an additional credit card or loan.
The cons of cash-out refinance
It’s important to consider both the pros and cons of cash-out finance. It’s not a perfect solution for everyone and carries some risks, including:
- Losing your home if you don’t make your mortgage payments
- Higher interest rate
- High closing costs
The most obvious risk is that you may lose your home if you don’t continue to make regular payments on your new mortgage. Also, there’s also a chance that you may actually end up with a higher interest rate than you already have, since refinancing changes the terms of your mortgage.
If your interest rate is going to increase by refinancing, you’ll need to do the math and consider whether that extra cash is really worth it. Without a lower interest rate than you currently have, it’s usually better to keep your current mortgage. Similarly, you’ll want to do the math on any closing costs you may be required to pay when you refinance. Closing costs vary, but most are hundreds or thousands of dollars. If it’s especially high compared to the cash you’re taking out, a cash-out refi may not be worth it.
Since a cash-out refi can take 15 to 30 years to pay off, you may not want to use this option for buying short-term or luxury items, like a new car or a vacation. You should really only consider using it toward improving your long-term financial situation, not putting yourself into greater debt and risking your home.
How a cash-out refi works
Just as with your original mortgage, when you refinance your home, there are clear steps involved in the process. Here’s what you should expect when qualifying and getting approved for a cash-out refi.
1. Provide documentation
When you apply for a cash-out refinance, you need to provide the same sorts of documentation required for your original mortgage. This includes tax returns, W-2s, pay stubs, bank statements, and a credit report. These documents help to ensure your creditor of your borrowing worthiness.
The requirements for a cash-out refi are not quite as strict as other types of home equity loans, but you’ll need a credit score of at least 640. You will also need to demonstrate that you have a low debt-to-income (DTI) ratio, which is the difference between your gross monthly income and your recurring debt such as credit cards and student loans.
3. Prepare for appraisal
The next step will be having an appraiser assess the value of your home. First, you want to make sure your home is in top shape in order to maximize the equity. You may want to improve your landscaping, clean the inside and outside of your home, and make any necessary small repairs or upgrades. You also should double-check that all your plumbing, lighting, and appliances are in proper working order.
4. Sign loan documents
After the appraisal process, you’ll be approved for the loan and you will need to order the proper loan documents and set up a date to sign them with your loan agent. Bring all your documentation with you to the signing appointment, and carefully read the loan documents. A notary or attorney should be present at the signing to help explain any documents to you.
5. Pay closing costs
After you’ve been approved, you’ll be required to pay any closing costs associated with refinancing. This could include an upfront mortgage insurance premium (UFMIP), appraisal fees, and escrow fees. These costs can vary, but they could amount to hundreds or thousands of dollars, so be sure to take them into account when determining whether cash-out refinancing is right for you.
Understanding the process, along with the main pros and cons of cash-out refinance is key to determining if it’s your best option. If not, there may be some suitable alternatives.
Alternatives to cash-out refi
There are many alternatives to cash-out refi if you don’t want to refinance your mortgage but still want to use your home equity in order to free up some cash. Depending on your unique financial situation, one of these options might work for you.
Take out a home equity line of credit
A home equity line of credit (HELOC) is essentially like using your home equity as a credit card. With a HELOC, you’ll be approved for up to 80 percent of your home value that you can borrow as needed.
Since a HELOC does not involve refinancing, the terms of your current mortgage will remain unchanged. You’ll probably pay higher interest on a HELOC than you would with a cash-out refi, but you’re only paying on the amount of credit that you actually use, so it may end up costing you less.
Use a home equity loan
A home equity loan is similar to a HELOC, but instead of borrowing only what you need multiple times, it allows you to borrow a lump sum of money which you repay with fixed monthly payments. The interest rate on the loan will be set up front and should stay fixed over the course of repayment, provided you make those payments on time. As with the HELOC, a home equity loan will let you borrow on your home equity without refinancing your mortgage.
Consolidate your debt with a personal loan
If you’re considering cash-out refinancing because you have debts you want to pay off, one alternative you might consider is consolidating that debt rather than refinancing your mortgage. By consolidating your debt, you’ll have all your accounts reduced to one convenient monthly payment, and you may end up with an overall lower interest rate than you have currently.
The lender will issue the loan in a single lump sum, then you use that money to pay off your debts and pay back the lender through regular monthly payments. The good news here is that your home isn’t being put at risk in order to get rid of some debt.
Consider debt settlement
Another possible option is debt settlement, which allows you to get out of debt without requiring you to take out a loan at all. When you enroll in debt settlement, a company working for you will negotiate with your creditors to reduce the total amount of debt you owe. If you are struggling with debt or are just worried about falling behind on payments, this might be an option for you. Freedom Debt Relief is here to help you understand all your options for dealing with your debt, including our debt relief program. Our Certified Debt Consultants can help you find a solution that will put you on the path to a better financial future. Find out if you qualify.