Cash-Out Refinance: A Beginner’s Guide
A cash-out refinance is a way to replace your current mortgage with a new one under new terms, and get an additional lump sum of cash in the process.
Essentially, it is taking out a new loan for more than your current mortgage balance. The new loan replaces your existing loan and you receive the difference between your old loan and your new loan (minus any applicable costs) in cash.
With conventional or FHA loans, lenders typically let you borrow up to 80% of your home’s value. For VA loans it can be up to 100%.
What Do I Need to Qualify for a Cash-Out Refinance?
Each lender has its own requirements for homeowners to qualify for a mortgage refinance. However, the most common minimum criteria for a conventional cash-out refi are:
A 620 credit score, although you will get a better rate if your credit is higher A debt-to-income ratio (DTI) of 50% or less A maximum loan-to-value ratio (LTV) of 80%, which means having at least 20% equity in your home after taking out cash
Lenders will require payment documentation, evidence of income, and a recent home appraisal (within the last 90 days).
Before considering a mortgage refinance of any kind, homeowners must make at least six consecutive payments to their original loan. To get a cash-out refinance on an FHA loan homeowners need to reside in the home for a minimum of 12 months.
How Does Cash-Out Refinance Work?
Verify the qualifications
Make sure you meet your lender’s requirements to qualify for a cash-out refinance loan before you apply. The minimum credit score for most types of refinancing is typically 580, but for a cash-out refinance, lenders often require a score of 620 or higher.
You’ll also want to know how much established home equity your lender requires — most will only approve your application if you have at least 20% equity in your home.
Your debt-to-income (DTI) ratio is another important factor to consider. This is the total of all your monthly debt payments divided by your gross monthly income. To qualify for most cash-out refinances, your DTI ratio needs to be 50% or lower.
How to calculate the required cash amount
Once you know how large a loan-to-value (LTV) ratio your lender can provide (typically, this maxes out at 80%, given the 20% home equity ownership standard), you can calculate the amount of cash you’ll be able to borrow. Multiply the lender’s maximum LTV ratio by the value of your home, and then subtract the balance of your existing mortgage. This will give you a rough estimate of the maximum lump sum you can apply for.
Submit application via your lender
The process for getting a cash-out refinance isn’t terribly different from a regular mortgage loan. You’ll fill out an application, supply the necessary supporting documents (like pay stubs and tax documents) and have the home appraised. After an underwriting period, you’ll close the deal; replacing your first mortgage with your newly-refinanced one, and receive a lump sum for the agreed-upon cash-out.
What’s the Difference Between Cash-Out and Rate-and-Term Refinance?
When it’s time to refinance your mortgage, there are two basic types of refinancing you can choose between: cash-out and rate-and-term.
While a cash-out refinance means getting a larger loan than what you currently owe, a rate-and-term refinance replaces your existing mortgage with a new one with different terms.
A rate-and-term refinance makes sense for homeowners who wish to lower their monthly payments (by getting a lower interest rate) or for those who wish to change their loan term, going from 30 to 15 years, for example.
Pros and Cons of Cash-out Refinance
Whether or not cash-out refinance is a good idea for you will always depend on your risk tolerance and financial situation. As with any mortgage refinance, you need to consider the break-even point, the time it takes for your monthly savings to equal the costs of securing this new loan.
If you refinanced your mortgage to save $250 per month, but the refinancing costs you $5,000, how long would it take to recoup that 5k? Divide 5,000 by 250 and you get 20. It will take you 20 months to make back the costs of refinancing, the break-even point. Everything after that is direct savings.
Tools such as a mortgage refinance calculator can help you in your decision.
Why Should I Get a Cash-Out Refinance?
Lower interest
The purpose of refinancing, in general, is to save money. That means securing a lower mortgage interest rate and as a result, lower monthly payments. Although a cash-out refinance has higher rates than traditional rate-and-term refis, with rates near historic lows it is still possible you’ll get a lower interest than your existing mortgage.
Pay off high-interest debt and debt consolidation
Credit card debt is higher-interest obligations that can quickly balloon to unmanageable levels. Under the right circumstances, paying them off with a cash-out refi can alleviate the immediate financial crunch.
Nonetheless, using your lower-interest home equity to pay off outstanding debt is not necessarily the wisest choice since the repayment term is spread out over a longer period (say, 30 years). Even with its higher interest, you might be able to pay off credit card debt sooner and pay less total interest.
College tuition
With the rising costs of higher education, the money from cash-out refinancing can allow you to pay you or your relative’s college tuition without having to enter into the higher-interest debt of a private student loan or federal parent PLUS loan.
Home improvements and repairs
One of the most common reasons for securing a cash-out refinance is for home improvements, upgrades, and repairs, which can help you twofold.
First, when done right, updating key areas of your home, such as the bathroom or kitchen, will often increase its value, thereby increasing your equity. In this situation, the refi almost pays for itself. Second, if you use the cash to improve your home you may be able to deduct additional interest payments from your taxes.
“Homeowners with sufficient equity can take advantage of the current historically low interest rates to secure tax-free cash for projects that can increase the value of their home,” says Bill Banfield, executive vice president of capital markets for Rocket Mortgage.
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Why Should I Avoid a Cash-Out Refinance?
Possible high, up-front closing costs
Some lenders will fold any closing costs or fees into your monthly mortgage payments or you could pay the closing costs upfront. These closing costs can vary between 2-5% of the loan amount, meaning a $150,00 cash-out refi requires a $7,500 out-of-pocket expense.
High break-even point
As mentioned, it’s important to calculate the break-even point in order to determine whether refinancing is right for you. High-break even points don’t provide the financial relief needed to justify cash-out refinancing, particularly if you’re thinking of moving within that time frame.
Foreclosure risk
No matter the purpose for which you decide to refinance, you’re going to be putting your home at risk if you ever default on your payment.
This is especially true if you’re using your cash-out refi to pay off credit card debt, as you’re basically exchanging unsecured debt for secured debt. Missing payments on a credit card can lead to penalties, credit score damage, and collections. However, defaulting on your mortgage can lead to foreclosure and the loss of your home.
A cash-out refinance also lowers your home equity, thereby increasing your risk of owing more than the home is worth if its value ever decreases.
Using the money for non-essentials
Even though a cash-out refinance provides tax-free cash, it’s not usually recommended for large purchases or expenses such as a new car or vacations for the same reason mentioned above: risking foreclosure to pay for a luxury or non-essential item is not a wise financial strategy.
Additionally, going through a cash-out refinance is basically the same as the original home buying process, with an appraisal and an underwriting period that can take a few months to complete. “If homeowners need money immediately, a cash-out refinance may not be the right solution,” adds Banfield.
Is It a Good Idea to Take a Cash-Out Refinance for Investing?
With some investment opportunities appearing to afford you a high rate of return, you might be tempted to consider a cash-out refinance to get extra funds for investing.
This, however, must be pursued with extreme caution. The volatility of investment markets, and the general unfamiliarity of how these markets work, can lead to personal financial turmoil.
“There are no restrictions to how a borrower can use the money. However, that also means accepting the full responsibility of spending the money in an appropriate manner that won’t put your home at risk,” says Banfield.
Buying additional real estate or investment properties could also be a consideration, especially if they generate rental income. But ultimately only a homeowner knows their tolerance of risk, and seeking out professional advice before determining how to proceed is essential. Risking your home and equity by trying to capture lightning in a bottle might not be a sound financial strategy
“Cash-out refinance programs are a great option for many consumers, but it is critical they work with a trusted mortgage lender or independent broker who takes the time to listen to their long-term goals and finds the option best suited to their needs,” Banfield concludes.
Alternatives to Cash-Out Refinance
If cash-out refinance is not right for your current situation, there are other options. Whether tapping into your home equity using a second mortgage or securing a personal loan, each option comes with its own set of advantages and disadvantages.
Home equity loans
Like cash-out refinance, home equity loans provide a one-time lump sum of money by using the equity accumulated in your home. However, unlike cash-out refinance, home equity loans create another lien on your home. This is why they are sometimes called a second mortgage. Monthly repayments must be made in addition to payments on your original mortgage, meaning that a default on a home equity loan could lead to foreclosure.
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Home equity lines of credit (HELOC)
Another type of second mortgage, a HELOC works similarly to a home equity loan in that it provides money by using the equity amassed in your home.
However, unlike the former’s lump-sum, HELOCs open a revolving line of credit. The lender determines the maximum credit line and you can borrow whatever you need during certain periods, which you can then repay and use again.
Banfield explains that the downside to home equity loans and HELOCs is that homeowners will usually pay a higher interest rate than with a cash-out refi, and they will take on an additional monthly payment. A cash-out refinance may also be an opportunity to lock in more favorable mortgage terms.
Reverse mortgage
Available for homeowners who are 62-years or older, a reverse mortgage also uses the equity to pay cash to the homeowner. However, because of government-set parameters, a reverse mortgage does not require the homeowner to pay back the amount before any specific period.
Nevertheless, you’re giving back your stake in the home to the lender in return for cash, and any heirs to the property will need to pay the loan back if they want to keep the home.
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Personal loans
Again, it boils down to your circumstances. Homeowners who don’t yet have enough equity in their home to apply for a cash-out refi or second mortgage might not have another alternative.
Personal loans usually come with higher interest rates than mortgages because they do not use collateral as a guarantee of payment.
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FAQs About Mortgage Refinancing
Home equity is the amount of your home you actually own. That is the difference between the amount you still owe on your mortgage and the home’s current market value.
For example, if your home is currently worth $300,000 and you owe $100,000 on your mortgage, your equity is $200,000 or about 67%.
You slowly increase your equity as you make monthly mortgage payments or if the value of the home increases. A decrease in home value can mean owing more than the home is worth, which is known as negative equity.
What is the break-even point?
In mortgage refinancing, the break-even point is the time it takes you to recoup the costs associated with the refinance (including closing costs and other fees) with the monthly savings you receive from it.
Although there is no defined break-even period goal, as it will depend entirely on each individual situation, the less time it takes to reach it the better. If you expect to sell before your break-even point is reached, it may not make sense to refinance.
What is the debt-to-income (DTI) ratio?
DTI is your combined monthly debt payments (including your new mortgage) divided by your monthly gross income, expressed as a percentage. It lets lenders know your repayment capabilities and, therefore, whether they can take the risk in offering you a mortgage loan.
Let’s say your monthly debt obligations are $2,200 ($1,200 for your mortgage, $500 for a car, and $500 in credit cards) and your monthly gross income is $5,500. Dividing your monthly debt by your monthly income gives you 0.4, or 40%. That’s your DTI.
What is loan-to-value (LTV) ratio?
LTV is the share of your home’s value you are financing.
Conventional and FHA mortgage refinances allow the homeowner to borrow up to 80% of the home’s value. But you don’t have to apply for the whole 80%.
If you owe $100,000 on your mortgage but your house is worth $300,000, you can do a cash-out refinance for $150,000 (a 50% LTV). You replace your original mortgage with a new one and the remaining $50,000 (minus applicable closing costs or fees) is provided to you as cash.
Lower LTVs typically help the chances your loan is approved and could lead to a lower interest rate.
What is a lien on a mortgage?
A lien is a claim to a property in the event a loan is not repaid. Lenders have a lien on your home when they provide you with a mortgage loan. If you default on your loan, the lien gives the lender the legal right to take the property back. However, lenders generally can’t start legal foreclosure proceedings unless you are more than 120 days past due.