Homeownership comes with many valuable benefits, including the ability to borrow money against your property.
While you should never borrow more than you can afford to pay back, there are several different types of loans available if you need the extra cash.
One of the most popular options is a cash-out refinance, a loan product that allows homeowners to refinance their existing mortgage while putting some extra cash in their pocket. Here is a closer look at a cash-out refinance and when it makes the most sense.
What is a Cash-Out Refinance?
A cash-out refinance is a type of mortgage refinancing where the borrower replaces an old loan with a new mortgage of an amount greater than what is still owed. The additional sum can then be distributed to the borrower as cash to do with what they wish.
Refinancing a mortgage has a variety of benefits for homeowners. If you've been consistent with your payments or your financial situation has changed since you first applied for the loan, you may get a better rate or be able to lower your monthly mortgage payments.
A cash-out refinance also gives you additional cash to pay off other debts or finance a large purchase. So, if done prudently, a cash-out refinance can be a way to reduce your monthly obligations and free up some cash to help pay additional expenses.
But it's still a loan guaranteed by your home, which means you could lose the property if you default. So, you should do some careful financial planning before you decide if a cash-out refinance is right for you.
How Does a Cash-Out Refinance Work?
First, the borrower must find a lender willing to issue them a loan. That could be the original lender who provided the first mortgage, or you can shop around and find a new lender that is willing to give you a better rate.
Either way, the lender will examine the existing loan and your financial credentials. Typically, you will need a fair amount of equity in the home to be approved or avoid a high-interest rate. Generally, you must have at least 20% to qualify for a refinance, although standards will vary from lender to lender.
The lender will then have you fill out an application and begin the underwriting process. This process will determine your risk profile and will be used to set your interest rate and the amount of money you are qualified to borrow. Cash-out refinances typically cap out at 80% of your home equity. However, there are exceptions, such as VA loans which allow borrowers to pull out 100% of their home equity. Also, keep in mind that you may need a new appraisal to confirm the home's value.
Your interest rate will vary depending on your existing financial credentials but expect it to be slightly higher than what it would be for a standard rate and term refinance.
Then, you will sign a new loan agreement if you accept the lender's terms. The new mortgage will replace your existing mortgage. Whatever amount you borrow beyond the amount you owe on your current mortgage will be distributed to you as cash, similar to a personal loan. You will then continue to make periodic payments until you pay off the debt.
So, say your home is worth $400,000, and you still owe $250,000. You could get a cash-out refinance for $280,000, which would give you $30,000 to spend on whatever you like. Remember that money will still be tacked onto the principal and have to be repaid. But it does help free up some cash that can be used for other life expenses.
When You Should Consider a Cash-Out Refinance
There are several scenarios where cash-out refinancing makes sense.
Because a physical property secures the loan, a cash-out refinance will typically feature a lower rate than a credit card or unsecured personal loan. So, if there is a major life expense you have to pay, then a cash-out refinance is often the cheapest option.
Common reasons to consider a cash-out refinance include:
- Consolidating debt (medical, student loans, credit cards, etc.)
- Home improvements and renovations
- Investments like a retirement account or college fund
- Pay for major life events like a wedding or funeral
A cash-out refinance is generally best for moving money around to pay a lower rate or to finance necessary expenses without accruing more debt through high-interest payments. But there are also situations where a cash-out refinance is not the wisest option.
When You Should Not Consider a Cash-Out Refinance
Even though a cash-out refinance is one of the cheapest ways to get a lump sum payment from the bank, it's still not advised in every situation. You're still using your home as collateral, which means if you default on the loan, you will go into foreclosure and possibly lose it. So, it's not wise to use the funds on anything frivolous.
For instance, you shouldn't use the funds to pay for any luxury items or finance a vacation unless you are very confident that you'll make the money back in other ways. This is an easy way to overextend yourself and potentially risk default.
You should also avoid cash-out refinancing if you're experiencing financial difficulties. For instance, if you recently lost your job, it isn't wise to try to use a cash-out refinance to get back on your feet. You will likely have a hard time being approved by a lender unless you are willing to pay a higher interest rate, leading to a domino effect that might only worsen a bad situation.
It's also not advised to get a cash-out refinance when interest rates are high. Otherwise, you might pay more interest than you originally paid on the first mortgage. In that case, other loan products are available that might make more sense.
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Cash-Out Refinance vs No-Cash Refinance
The main difference between a cash-out refinance, and a rate and term refinance (or no cash refinance) is that you will never hold any of the actual funds with the latter.
A no-cash refinance aims to get a better rate, reduce your monthly obligation, or make some other alteration to your mortgage. But you won't have access to any additional funds once the loan is approved.
As a result, no-cash refinancing typically features lower interest rates than cash-out refinancing. So, if you don't need the additional funds and mainly want a better rate on your mortgage, a no-cash refinance is the wisest option.
Cash-Out Refinance vs Second Mortgage
Although they are similar, a cash-out refinance differs from a second mortgage.
A second mortgage is when you have two separate loans secured by one property, whereas a cash-out refinance is a large first loan that replaces your existing mortgage.
There are two common types of second mortgage, a home equity loan and a home equity line of credit (HELOC).
Cash-Out Refinance vs Home Equity Loan
A home equity loan is similar to a cash-out refinance, but there is a key difference.
Both use your home equity as collateral to secure a cash loan; however, you are not replacing your original mortgage with a home equity loan. With a home equity loan, your original mortgage stays intact, and you take out an entirely different loan secured by the equity.
As a result, home equity loans tend to feature higher rates than cash-out refinancing and require their own regular payment on top of your current mortgage payment.
Cash-Out Refinance vs HELOC
A home equity line of credit (HELOC) is another popular loan product similar to a home equity loan.
The main difference is that a home equity loan is disbursed as cash, which the borrower receives all at once. A HELOC is disbursed as a line of credit, which the borrower can use as they please. So, similar to a credit card, the borrower can use only what they need and pay back whatever they borrow.
A HELOC differs from a cash-out refinance in that it's still a second mortgage. Also, with a cash-out refinance, the borrower receives the funds as a lump sum payment, not a credit line. So they will still have to pay back all the money, even if they don't use it all.
A cash-out refinance will often extend the lifetime of your mortgage, whereas a HELOC will simply add a second payment to your existing mortgage schedule. But, cash-out refinances are generally considered less risky and, therefore, often feature more favorable rates.
Is a Cash-Out Refinance a Good Idea?
A cash-out refinance can be a smart, relatively inexpensive way to tap into your home's equity. It often features lower rates than a second mortgage or an unsecured loan like a credit card and can be used to pay for important life expenses.
But it's still a major financial commitment that carries consequences if not repaid on time. If you default on the loan, it could ruin your credit and put you at risk of foreclosure. So it's essential to weigh the pros and cons and make sure that it's really the best move for your financial situation.