What was once your dream home now needs some major updates. You can’t take another day in that dirty, outdated kitchen full of old appliances that don’t work. But how can you afford a major renewal on top of the monthly payment? The mortgage payment and everything else? A cash-out refinance could be the answer.
You pay off and replace your current mortgage with a new, larger mortgage in a cash-out refinance. The difference between the old and new mortgage amounts, less closing costs, is yours – in cash.
To qualify, you must have equity; that’s the difference between the value of your home and the amount you owe on your mortgage. Equity is what you are borrowing against. But there are pros, cons, and risks involved. Read on to learn more about cash-out financing and if it’s the right option for you.
What is a cash-out refinance?
Cash-out refinancing is a loan option for homeowners who want to capitalize on the equity they’ve put into their property. Different from traditional refinancing, where your new loan replaces your mortgage with a loan of the same amount, a cash-out refinance your current mortgage with a larger loan. Most lenders will allow homeowners to borrow up to about 80% of their home’s equity. The difference will be paid back to you in cash, and you can use the lump sum in any way you choose, including for home improvements and even debt consolidation.
For example, let’s say your home is valued at $300,000, and you still owe $100,000 on your mortgage; the $200,000 difference is your equity. If you opt for a cash-out refinance, lenders typically require you to keep 20% of your home’s equity, or $60,000 in this case. You could withdraw up to $140,000 to use for that new kitchen.
Before you do a cash-out, refinance
- Check out each lender’s cash-out refinancing requirements, as they will differ by institution. For example, some lenders will allow you to borrow only up to 80% of your home’s equity, while others will let you borrow up to 90%.
- Make sure you have at least 20% equity in your home, as this is often the percentage lenders require before considering you for a cash-out refinance.
- Get your credit score to a good place, preferably above 670. Lenders will consider your credit history, score, and debt-to-income ratio. They will also see his employment and how long he has lived in his house.
Benefits of Refinancing With Cash Out
While cash-out refinancing isn’t for everyone, here are some potential benefits.
It can help you consolidate and pay off your debts. : You can use the difference you get from your new home loan to pay down your debt or transfer it to an account with a low-interest rate. By paying off your debt, you could also improve your credit score.
It helps you make home improvements. : Use the cash to finally renovate your kitchen, build an addition, or maybe redo your deck. By investing in your home, you increase the value of your home.
Could give you a tax break: Refinancing with cash out could qualify you for a mortgage interest deduction, a tax break that allows you to reduce the amount you pay in taxes based on the amount of mortgage interest you’ve paid on your home during that time.
It could lower your interest rates: Whether you opt for a traditional or cash-out refinance, you should be able to get a lower interest rate, especially if your new loan is larger than the original. Refinance interest rates are generally lower than home equity or credit card rates. This could end up saving you thousands of dollars in the long run.
Disadvantages of Refinancing with Cash Out
There are downsides. Here are some other things to consider before committing to a new, larger loan.
Increases your risk of foreclosure: Home loans are secured, which means they are tied to a piece of collateral, namely your home. If you stop making your loan payments, you could lose your home. That’s why using the money you receive from a cash-out mortgage to pay off an unsecured loan, like a credit card, is considered risky.
You will change the terms of your loan: Because you are taking out a new loan, you will most likely have to accept new terms for your mortgage. You’ll want to check out the latest interest rates, fees, and term length before you agree to the loan.
You could be paying for private mortgage insurance: If you borrow more than 80% of your home’s equity, you may have to pay PMI, which will only add to your expenses. PMI can cost you between 0.55% and 2.25% of your new mortgage.
You’ll pay closing costs: Just like when you bought your home, you’ll need to pay closing costs when you refinance. Usually, this is 2% to 5% of your total mortgage.
Alternatives to refinancing with cash out
A HELOC, or home equity line of credit, offers homeowners separate loans with revolving credit instead of one large loan. However, you will still have to pay the closing costs for a HELOC, and your home will still be used as collateral.
Going with a personal loan is another route to access money for your home improvement projects, with the added bonus of not having to use your home as collateral. But because it’s an unsecured loan, you’ll have much higher interest rates than you’ll find with a cash-out refinance.
If you’re 62 or older and want to make home improvements, you can apply for a reverse mortgage to finance those upgrades. A reverse mortgage allows you to take advantage of the equity in your home and frees you from monthly mortgage payments. But it depletes your principal, which means fewer assets for you and your heirs. And the borrowed amount will have to be repaid when the owner moves out of the house, sells the property, or dies.
Home Equity Loan
Like cash-out refinancing, home equity loans provide you with a lump sum of cash. Home equity loans will not alter the terms of your loan, unlike a cash-out refinance, and the interest rate is fixed. But since it’s a second mortgage, with a separate payment, that interest rate tends to be much higher than a first mortgage.