One benefit of homeownership is...
The ability to build equity.
A renter might spend thousands on rent each month, but never have a stake in their property.
Since they’re paying their landlord’s mortgage, there’s no financial benefit when they move out.
On the other hand, every mortgage payment a homeowner makes goes toward reducing their mortgage balance and building their equity.
And when they move and purchase another house, money from the sale of their property can be used as down payment on their next property.
But equity isn’t only useful when selling a home.
It also comes in handy when refinancing. This is because homeowners have the option of cashing out a percentage of their equity.
What is a Cash-Out Refinance?
A cash-out refinance is like a regular refinance, in that you apply for a new mortgage loan to replace your existing loan.
Refinancing a mortgage can result in better home loan terms.
This is good news if you’re currently paying a high interest rate and you want a lower rate.
A lower rate can possibly reduce your mortgage payment and free up cash for other purposes.
A cash-out refinance is slightly different from a regular refinance.
With a regular refinance, the primary goal is to acquire a new mortgage and modify your terms. With a cash-out refinance, you’re also tapping your equity and getting cash at closing.
The amount you’re able to borrow depends on how much equity you have.
Typically, lenders allow borrowers to cash out up to 80 percent to 85 percent of their home’s equity.
How Does a Cash-Out Refinance Work?
The first step to getting a cash-out refinance is applying for a new mortgage loan.
You can refinance with your existing mortgage lender if you’re happy with the mortgage company.
But there’s no obligation to stick with your current lender. In fact, some financial experts recommend shopping around and requesting multiple quotes.
Speak with at least two or three different mortgage lenders.
This way, you can compare interest rates and loan terms to ensure you’re getting an excellent deal.
When filling out a mortgage application, you must specify your desire to cash out your equity.
Along with submitting your application, you’ll provide the lender with supporting documentation.
These documents include:
- W2s or tax returns from the previous two years
- recent paycheck stubs
- bank account statements for the past 60 to 90 days
You might also submit a year-to-date Profit and Loss statement if you’re a self-employed borrower.
Maintain good credit
Next, you’ll authorize a credit check.
Keep in mind that a mortgage refinance approval isn’t guaranteed. You have to re-qualify for the new mortgage.
If your income or credit score has changed (for the worse) since applying for the original mortgage, this change could jeopardize getting a cash-out refinance.
Ideally, you should wait until your credit score is high enough to qualify for a favorable interest rate.
You can refinance with a credit score as low as 580 to 620.
For the best mortgage rate, aim for a credit score of at least 720 to 740.
Paying your bills on time and paying down debt helps raise your personal rating.
If you meet the qualifications for a cash-out refinance and decide to proceed with the loan, the next step is a home appraisal.
Get a home appraisal
This determines your property’s worth.
A third-party company performs the home appraisal.
The appraiser walks through your property and assesses its condition. The appraiser will then pull comparable sales of similar homes in your neighborhood. This information helps gauge your home’s value.
As a general rule of thumb, you can’t refinance for more than your property’s worth.
Let’s say you want to refinance for $250,000, but the appraisal determines that your home is only worth $245,000.
In such a scenario, you’ll have to pay $5,000 out-of-pocket to proceed with the mortgage refinance.
Or, you can request a second opinion and hope for a higher appraisal on the second round.
It’s also important to note that just because you’re able to borrow up to 85 percent of your equity doesn’t mean a mortgage lender will approve a cash out of this amount.
A cash-out refinance isn’t free money, so you must repay every cent.
Mortgage lenders add the borrowed amount to your mortgage balance.
Since you’ll end up owing more money, your mortgage payment will likely increase.
The good news is that getting a better mortgage rate might be able to minimize this increase.
But there’s no guarantee.
That being the case, you can only cash out what you can afford to pay it back. Your income and current debt load determine affordability.
Why Apply for a Cash-Out Refinance?
A question remains, why get a cash-out refinance?
Plenty of reasons justify borrowing money from your equity.
But since you’re putting your equity and home on the line, don’t borrow money for the sake of getting cash.
Rather, only cash out your equity when necessary, and only for purposes with long-term benefits.
In other words, it’s not smart to borrow cash from your equity for an elaborate European vacation. If you’re unable to repay what you borrow, you could end up losing your home and damaging your credit score.
One smart use for a cash-out refinance is a home improvement project.
Maybe your property is in need of repairs. Borrowing cash from your equity can modernize the space and improve the condition of the home.
And as a result, your home’s value increases.
This helps you recoup your equity faster.
Paying for college
Some people also get a cash-out refinance to pay for a child’s educational expenses.
Before you borrow from your equity to pay for college, make sure you consider other alternatives such as private or federal student loans.
Many student loans have low fixed-rates with the option to make payments while in school. In-school payments can reduce how much you or your child owes after graduation.
Others might use a cash-out refinance to pay off high interest credit card debt. But before using your equity for this purpose, consider the pros and cons.
On one hand, paying off high interest credit card debt can improve your credit score. This is because you’re able to reduce your credit utilization ratio.
This ratio refers to the percentage of outstanding revolving debt in comparison to your credit line.
Revolving debt is a riskier type of credit because its unsecured and doesn’t have a fixed payment amount. Therefore, too much credit card debt can damage a person’s credit score. But if you paid down these balances, your credit score might improve.
Typically, credit card balances should never exceed 30 percent of your credit line.
Even though funds from a cash-out refinance can pay off credit cards and boost your credit score, only use your home’s equity if you are confident in your ability to manage credit responsibly.
Unfortunately, some people use their home equity’s to pay off credit card debt and then re-accumulate balances. In the end, they double their debt.
Alternatives to a Cash-Out Refinance
Keep in mind that a cash-out refinance involves expenses.
You’re creating a new mortgage, so you’re also responsible for paying closing costs.
Closing costs can range from 2 percent to 5 percent of the loan balance.
Maybe you prefer a less expensive means of getting your hands on cash. If so, you might look into getting a personal loan instead.
A personal loan may carry a higher interest rate than a cash-out refinance.
Additionally, you might have to pledge some type of personal property as collateral. On the upside, getting a personal loan is less expensive and may involve no upfront costs.
You can also talk to your bank about a home equity line of credit (HELOC) or a home equity loan.
These options can have higher rates than a cash-out refinance. But on the other hand, both options tend to have cheaper closing costs compared to a cash-out refinance.
Conclusion: When Does a Cash-Out Make the Most Sense?
Despite the benefits of a cash-out refinance, this type of refinance doesn’t make sense for everyone.
Even if you’re putting the cash to good use and can qualify for a low mortgage rate, consider how long you plan to live in the house before proceeding.
Due to the expensive nature of these loans, a cash-out refinance only makes sense if you live in the home long enough to recoup what you pay in closing costs.
Divide your monthly mortgage savings after refinancing by the amount of your closing costs to calculate the breakeven point.
For example, if you’ll pay $3,500 in closing costs for a cash-out refinance, resulting in a monthly savings of $250, you would need to keep the mortgage for at least 14 months to justify refinancing.