What Is A Cash-Out Refinance And How Does It Work?
Sarah Sharkey9-minute read
June 16, 2022
As a homeowner, a portion of every mortgage payment builds equity in your home. But it’s not cash. However, if you run into a major expense, that mountain of home equity could provide the solution. You could pull out the funds through a cash-out refinance.
Let’s explore what a cash-out refinance is and see how this financing option could be a solution for your financial needs.
Cash-Out Refinance Meaning
To understand what a cash-out refinance is, you first need to understand equity. Equity is the amount of the home’s value that belongs to you; it’s the value that doesn’t have any debt attached to it.
To make this simple, let’s look at an example. Say you buy a house for $200,000. You make a 20% down payment, equal to $40,000, and pay for the rest using a mortgage loan. Right off the bat, you’ll have $40,000 worth of equity in your home and owe $160,000 on your mortgage. Then, as you make your monthly mortgage payments, you’ll continue to build equity, little by little.
Once you’ve built sufficient equity in your home, a cash-out refinance home loan lets you turn that equity into cash by replacing your existing mortgage with a new one for a larger amount than what you owe and letting you pocket the difference.
With that cash in hand, you can pay for renovations, consolidate debt, or cover other expenses.
How Does A Cash-Out Refinance Work?
Let’s go back to our example. You own a $200,000 house. After making mortgage payments on the home for a few years, you’ve paid down your balance to $100,000. So, you have $100,000 of equity in your home.
You’ve decided to remodel your kitchen; you’ve done some research, and you think that a new kitchen will give your home a modest boost in value. Plus, you really think a new kitchen will improve your quality of life. You’ve determined it’s going to cost about $20,000.
To get the cash for your remodel, you decide to do a cash-out refinance. You get a new mortgage for $120,000. From this new loan, $100,000 pays off your existing mortgage, and the remaining $20,000 is given to you as a lump sum.
After the cash-out mortgage refinance is finalized, you'll start making monthly payments on the higher loan amount. Typically, there’s a limit to how much cash you can take out of your home. Most lenders won’t let you go below 20% equity. If you can go below 20%, keep in mind that you’ll likely have to start paying for mortgage insurance.
One exception to the 20% limit is if you have a VA loan. With a VA loan, you may be able to take out 100% of your equity if your FICO® Score is 620 or higher. With a lower credit score, you may only be able to access 90% of your equity.
The Pros Of A Cash-Out Mortgage Refinance
Every financial product has advantages and disadvantages. Here’s a look at the pros of a cash-out mortgage refinance.
You’ll Only Have To Manage One Loan
When you pursue a cash-out refinance, you’ll replace your current mortgage with a new loan that includes the cashed-out amount. After the loan is finalized, you’ll still only have one mortgage payment. Instead of balancing multiple loans, you can stick to making a single monthly payment.
You’ll Have More Borrowing Potential
Depending on the amount of equity you’ve built in your home, you could tap into an extensive amount of borrowing potential. Although you could choose to apply for a personal loan or credit card, these options usually have a lower loan limit.
Access to more borrowing power is critical if you have a major expense to cover.
There Are No Use Restrictions
Unlike some other loan types, you won’t run into any restrictions on how you use the funds from a cash-out refinance. So, you can use the funds for anything you need. Common ways homeowners use equity include paying for home repairs, home improvements, college tuition, vacations, medical bills and debt consolidation.
The Cons Of A Cash-Out Mortgage Refinance
Of course, there are also some disadvantages to consider with cash-out refinances.
It Will Increase What You Owe
The most obvious disadvantage of a cash-out refinance is that you’ll increase your mortgage balance. Taking on more debt can negatively impact your long-term financial goals.
Keep in mind that a cash-out refinance is a mortgage, and if you aren’t able to make payments on it, you risk losing your home to foreclosure. Make sure that your new mortgage payments will be manageable for your budget so you don’t risk putting your home in jeopardy. While cash-out refinances can be helpful for debt consolidation, you take a risk when you turn an unsecured debt like credit card debt into a secured debt.
You’ll Have To Pay Closing Costs
A cash-out refinance is a mortgage product. And with that, you’ll have to pay closing costs on the loan. A few expenses to expect during the closing process include an appraisal fee, inspection fees and other lender fees.
In some cases, the closing costs associated with a mortgage are significantly higher than alternative financing opportunities.
You’ll Be Agreeing To New Loan Terms
When you refinance your mortgage, whether you’re doing a cash-out transaction or just lowering your rate, you’re changing the loan’s amortization (the time and amount of money it takes to pay off the loan). If you’re currently 5 years into a 30-year loan term, refinancing could mean resetting the clock from 25 years back to 30.
Additionally, if you got your mortgage when interest rates were lower than they are now, refinancing might not make sense for you because you’d likely be taking on a higher interest rate.
Since interest rates fluctuate over time, you might find higher or lower interest rates than your original mortgage. If interest rates are lower than when you first took out the mortgage, that could work out in your favor. But if interest rates are higher than when you first took out the mortgage, you might end up with significantly higher monthly payments.
You May End Up Paying Private Mortgage Insurance (PMI)
Most lenders expect borrowers to pay private mortgage insurance (PMI) if they borrow more than 80% of the equity in their home. PMI is an extra monthly expense that is added to your mortgage payment. If you want to avoid PMI, then you shouldn’t borrow more than 80% of your home’s equity.
But if you need to borrow more than 80% of your home’s equity, then expect to pay PMI until you’ve built back to 20% equity in your home.
Ultimately, you’ll need to run the numbers of your unique situation to determine if a cash-out refinance is a cost-effective solution. If you’ll end up with a higher mortgage payment, consider how that would impact your budget.
Other Ways To Use The Equity In Your Home
If you have a major expense that you want to cover with home equity, a cash-out refinance isn’t the only option you have. As a homeowner with equity in your home, there are other loans to consider. Here’s a closer look at the other ways to tap into your home’s equity.
Home Equity Loans
A home equity loan, also known as a second mortgage, is a type of loan that allows you to borrow against your home’s equity. Essentially, you’ll use the equity you’ve built in a home as collateral for a second mortgage.
You’ll receive the funds from a home equity loan in a lump sum. From there, you’ll start making regular monthly payments to repay the loan.
When you take out a home equity loan, you won’t have to touch your primary mortgage. With that, you can keep your interest rate and continue on the original repayment track.
But with a second mortgage comes a second payment to keep up with. Plus, you’ll encounter a higher interest rate attached to these loans due to the higher level of risk perceived by the lender.
Home Equity Lines Of Credit (HELOC)
A home equity line of credit, or HELOC, is secured by your home’s equity. Through this lending product, you can withdraw funds as needed up to a certain credit limit. When you take out funds, you’ll start making payments.
A HELOC provides an increased level of flexibility to homeowners. It essentially allows you to quickly tap into your equity when you need to. But you won’t have to withdraw the funds until you need them.
HELOCs often come with variable interest rates that rise and fall with the market. The fluctuations can make it difficult to stick to your budget, and the second loan payment can put a strain on your finances. But the flexibility and relatively low interest rates of a HELOC make it an option worth considering.
A personal loan is an installment loan that you’ll repay on a fixed timeline. Unlike the other options on this list, a personal loan is not secured by your home’s equity. The unsecured nature of this loan type means there is no risk of losing your home because it is not being used as collateral.
Instead, a personal loan is granted based on the qualifications of the borrower. A lender will evaluate your credit score, credit history, income, and more to determine what they are willing to lend you.
When taking out a personal loan, you can receive the funds quickly. Since there is no attachment to your home’s equity, the lender doesn’t need to dive into the details of your home’s value. Without this time-consuming issue slowing down the process, you could receive the funds you need in as little as one day.
But without any collateral, unsecured personal loans often come with higher interest rates. When combined with the relatively short repayment timelines of 2 – 5 years, you might face a relatively high monthly payment.
Is A Cash-Out Refinance Right For You?
Now that you’ve seen the other options out there, it’s time to decide whether or not a cash-out refinance is the right fit for your situation.
Here’s when a cash-out refinance could be the right move.
You’ve Built Up Equity In Your Home
If you’ve built up a substantial amount of equity in your home, then a cash-out refinance is a viable option. But if you are a relatively new homeowner with minimal equity, then a cash-out refinance likely won’t cover a significant expense.
You Have A High Credit Score
A reasonably high credit score offers the opportunity to tap into lower interest rates. If you have a low credit score, refinancing could lead to higher interest rates and monthly payments.
You Know How Much Funding You Need
A cash-out refinance is a one-time transaction. Unlike a HELOC, you won’t be able to withdraw more funds without going through the lending process again. With that, it’s important to know exactly how much money you need to cover an expense.
For example, if you are paying off a medical bill, then you’ll know exactly how much to borrow. If you are paying for a home renovation, a loose budget could mean not borrowing enough funds.
If you aren’t sure exactly how much money you need to borrow, then a HELOC is a better option.
You Can Tap Into A Better Interest Rate
If refinancing the mortgage will give you the same or better interest rate, then a cash-out refinance is a useful opportunity. If you are facing significantly higher interest rates, then this loan type could be prohibitively expensive.
You Don’t Plan On Borrowing More Than 80% Of Your Home’s Equity
Remember, most lenders will require an extra private mortgage insurance payment on top of your regular monthly payment if you borrow more than 80% of your home’s equity. Unfortunately, this extra expense will stick around until you’ve rebuilt at least 20% equity in your home. Take this extra cost into consideration before moving forward.
You Can Cover The Closing Costs
A refinance of any kind of mortgage will come with closing costs that can add up quickly. Having some cash on hand to cover your closing costs is critical as a borrower.
You Can Wait To Receive The Funds
A cash-out refinance is not a speedy process. The exact timeline will vary, but on average homeowners should expect it to take 30 – 45 days to finalize a cash-out refinance. If you need the funds faster, then a personal loan might be a better option.
The Bottom Line
A cash-out refinance allows homeowners to easily access the equity in their homes. As a homeowner, you can use the equity you’ve built in your home to cover the expenses you face. Although a loan of any kind will increase your monthly debt obligations, the relatively low-interest rates can make a cash-out refinance an attractive opportunity.
If you are interested in a cash-out refinance, apply with Rocket Mortgage® today.
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