How Do Cash-Out Refinances Work?

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If you’re a homeowner looking to take advantage of the equity you’ve built in your home, you might consider how a cash-out refinance could help you meet your financial goals. Like any financial decision, it’s best to get a good look at how this might impact your finances as a whole. In this post, we’ll answer the following questions, and more.

What Is A Cash-Out Refinance?

A cash-out refinance is a loan that allows homeowners to use the equity they’ve built up in their home to take out a lump sum of cash to help take care of expenses, such as home repairs, improvements, or to pay off high-interest debts. Cash-out refis can technically be used for whatever the borrower pleases, but certain uses may be more beneficial than others.

Why Do People Refinance?

There are several reasons people choose to refinance their mortgage with a cash-out refinance or another refinancing method. Here are a few of the most common:

Reducing Your Interest Rate: Refinancing your loan could help you secure a lower interest rate than you had when you got your original loan – especially if your credit score has improved. When you refinance with a lower interest rate, more of your monthly payment goes toward the principal rather than interest, which could also help you pay off your loan quicker!

  • Lowering Monthly Payments: With 35% of homeowners struggling to pay their mortgage, it’s no wonder people consider refinancing for a lower rate. A refinanced loan can help make your mortgage payments more manageable by lowering your monthly balance. This can give your budget more flexibility, but keep in mind, it could mean that you’re extending the lifetime of your loan since you’ll likely need longer to pay it off.
  • Adjusting Loan Type: If you’re unhappy with your current mortgage, refinancing it could make managing your finances easier. Let’s say you have an adjustable rate mortgage, but you’d prefer to have a fixed-rate mortgage – or vice versa – a refinanced mortgage could get you the loan type you want. Cash-out refis typically have fixed interest rates.
  • Consolidating Debt: Another potential benefit a refinanced mortgage can offer is the ability to consolidate your debt. Since refinances typically have lower interest rates, they can be used to pay off high-interest debts, such as credit card balances.

Use Home Equity: The most common reason people use cash-out refinances specifically, is that they allow you to gain access to cash quickly. If you need to make some repairs, or want to increase the value of your property, this extra money can help you cover the expenses.

How Does A Cash-Out Refinance Work?

Now that you know the basics of cash-out refinances, let’s take a closer look at how they actually work.

Cash-out refinances allow homeowners to take out between 80 – 90% of their home equity.[1]  Equity can be earned through the following methods:

  1. Your home increases in value.
  2. Each time you make a mortgage payment, you gain more equity in your home.

To qualify for a cash-out refinance, lenders will expect you to have a certain amount of equity built up in your home. (We’ll discuss more on how you can apply for a cash-out refinance a little later on in this post.)

When you get a cash-out refinance, the lender allows you to convert the equity you’ve built in your home into cash in exchange for a larger mortgage. Unlike a second mortgage, a cash-out refinance is a single, larger loan that pays off and ultimately takes the place of your original mortgage. When you pay off your original loan, your relationship with that lender is terminated and you move forward with your refinanced loan. In other words, the refinanced loan is used to pay off your first loan and now you’ll need to pay off the remaining balance with your new lender.

Let’s take a look at an example to help you get a better understanding of how cash-out refinances work:

Hunter bought a home for $450,000 and has paid off $100,000 of her original mortgage, leaving her with a balance of $350,000. She has an electrical issue that will cost her $5,000, and she also wants to renovate her kitchen to help increase the value of her home, which will cost $30,000. So, she’ll want to borrow a total of $35,000 via cash-out refinance.

Remember, Hunter owes $350,000 on her mortgage so if she takes out a cash-out refi, her new mortgage is:

$350,000 + $35,000 = $385,000

Pros And Cons Of Cash-Out Refinances

Your home is likely one of the biggest investments you’ll make in your lifetime, so it’s important to think critically before deciding if you should take out a cash-out refinance. Here are some of the pros and cons you might want to consider before following through with a cash-out refinance.

Pro: You Can Make Home Improvements And Renovations

You can use the money you take out from a cash-out refi to reinvest in your home by making improvements to your property. From leaky faucets to adding amenities, cash-out refinances can be a great way to add value to your home.

Pro: You Can Consolidate Debt

Another way you can use the borrowed funds from a cash-out refinance is to help you consolidate high-interest debt, like credit cards.

Pro: You Can Get A Lower Interest Rate

As we mentioned before, getting a lower interest rate is one of the main reasons homeowners choose to refinance their mortgage. If you’ve built up equity in your home and raised your credit score, you may be able to secure a much lower interest rate than your original mortgage. This means more of your monthly payments go toward paying off the principal rather than interest payments.

Con: You Still Have To Leave Equity

Cash-out refinances don’t enable you to take out all of the equity you’ve built in your home. Lenders typically require homeowners to leave 15-20% equity in their home. This means that you should consider whether the amount of equity you can take out is enough to accomplish your financial goals.

Con: Associated Fees

To take out a cash-out refinance, you’ll likely need to pay several associated fees which, depending on the cost, could mean it might not make financial sense if you don’t plan on staying in the home long enough to break even or recoup that cost. Here are some of the fees you might expect to pay when refinancing:

  • Appraisal fees
  • Closing costs
  • Attorney expenses
  • Credit report fees

Con: Changing Loan Terms

When you refinance your mortgage, you’re replacing your original mortgage with an entirely new one. This means your interest rate and loan terms (maturity date, monthly payments, etc.) are all likely to change. Ideally, these modified loan terms would work in your benefit, but it can be challenging for some homeowners to adjust.

Con: Risk Of Foreclosure

If you opt for a cash-out refinance, you’re putting your property on the line in favor of quick cash because cash-out refis use your home as loan collateral. This means that if you fail to make your loan repayments, you could run the risk of having your home foreclosed.

How To Apply For A Cash-Out Refinance

If a cash-out refinance seems like the right move for you, here are a few tips to help you apply.

  • Check the requirements: Lenders each have their own set of criteria for approving cash-out refinances, so before you apply, you might want to see how your financial profile stacks up to their guidelines.
    • Lenders typically require a credit score of 620 or higher for cash-out refinances.
    • Certain cash-out refis, like Fannie Mae loans, require a debt-to-income ratio of less than 45%.
    • To take a cash-out refinance, you’ll need to have equity in your home and your lender may even require you to have a minimum amount. However, keep in mind that you cannot access all of your equity, unless it’s a VA loan which allows you to cash out 100%.
  • Consider how much cash you need: As we mentioned, your lender will only allow you to take out a certain percentage of your home equity, meaning that there’s a limit on how much cash you are able to take out. If you need $35,000 to complete the renovations that you need, but you can only borrow $20,000, a cash-out refi might not make the most sense for your current situation.
  • Gather supporting documents: Your lender may request certain supporting documents (in addition to your credit report) before approving you for a loan. It’s a good idea to collect these documents ahead of time in order to expedite the process. Some of the documents you may need include:

○        Bank statements

○        W-2s

○        Pay stubs

  • Key Takeaways

    • A cash-out refinance is a loan that allows homeowners to convert their home equity into cash.
    • Cash-out funds can be used to cover any expenses, but are often used to help homeowners reinvest in their property.
    • Another way cash-out refis can be used is to pay off high-interest debts like credit card debt and student loans.
    • Cash-out refinances offer several potential benefits, but there are also some potential drawbacks to consider, such as:

    ○        Risk of foreclosure

    ○        Changing loan terms

    ○        Associated fees

    Is a cash-out refinance right for you? It depends. Using this guide, you can consider some of the potential risks and rewards of refinancing your mortgage. If you’re not sure if a cash-out refinance is the best move for your financial situation, consider seeking the help of a financial expert for more tailored advice!

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