Cash-Out Refinance: Everything You Need To Know
It’s not unusual to be short of money. Whether you’re repaying debts like mortgage, auto payment, credit card, student loans or managing bills for utilities, insurance, education, healthcare and what have you. The list goes on, but what they have in common is that when added together, its completely reasonable to be cash-strapped at some point.
A cash-out refinance can help you stay afloat.
What Is Cash-out Refinance?
If you have enough equity, you can refinance your current mortgage for a new one whose amount is greater than the existing one. You then pay off the original mortgage, and the amount that remains is yours to use.
That is what is called a cash-out refinance or cash-out refi. It involves refinancing a mortgage for more than what you currently owe and taking the difference in cash.
Like other types of refinance, the cash-out option lowers your interest rate and subsequently your monthly mortgage payments. You may also adjust the term of the loan and secure a more favorable deal while at it.
The major difference with other refinance options is that you get cash in the process.
Cash-Out Refi Example
Assume you purchased a house some years back using a mortgage worth $250,000. And while you have been making payments on the loan, your home’s value has appreciated. Let’s say you currently owe $150,000 on the mortgage, and the house has a fair market value of $280,000. The equity in your home will be $130,000.
If you find yourself in a financial crisis, you can refinance the current mortgage of $150,000 for a bigger mortgage, say $200,000. You then repay the original mortgage of $150,000 and the $50,000 that remains is yours to use.
The home’s equity will reduce from the original $130,000 to $80,000 (280,000 – which is the value of the house, less 200,000 – which is the value of the new mortgage).
As you can see, a cash-out refinance converts some equity into cash. That’s why it’s known as “tapping into your home’s equity.”
Which Mortgages Allow For a Cash-Out Refinance?
Nowadays, you can do a cash-out refi for any type of mortgage loan, including a jumbo. Here are the options:
1) Conventional cash-out refinance
Available for conventional mortgage holders. You need to have at least 20% equity to qualify for this.
2) FHA cash-out refinance
Meant for homeowners who currently have the FHA home loan. You are eligible if you have at least 15% equity.
3) VA cash-out refinance
This one is for the veterans and service members who qualify for a VA mortgage. Although some lenders allow refinancing 100% of the home’s value, most prefer to limit it to 90%.
4) Jumbo cash-out refinance
For homeowners with jumbo mortgages. This option has stricter eligibility requirements and limits refinancing to 70% of the home’s value.
Keep in mind that each type of mortgage refi has its own eligibility requirements. The lender will look at things like your credit score, equity (loan-to-value ratio), income, assets, and interest rate (relative to the current market rate) before approving your application.
Want to know which type of refinancing you qualify for? Contact us today, and our mortgage officers will walk you through the options that you qualify for, and the ones that suit you best.
Using the Cash
Lenders typical don’t put any restrictions or limitations on how you can spend the cash from a refinance. That leaves you with unlimited options, ranging from paying down debts to settling bills or even taking a vacation.
But of course, in practice, you want to make sure that the money goes to the most important use. You can use it to:
- Consolidate your debts: paying off high-interest debts like credit cards will allow you to save more, improve your credit score, and transfer the credit card debt to a mortgage debt which is usually tax deductible.
- Pay closing costs: rather than rolling the closing costs of your cash-out refi into the loan, you can pay them upfront. Otherwise, they will be part of the mortgage, and you will have to pay interest on them.
- Improve the home: doing repairs and upgrades will increase the value of your home in the long run. So that too makes financial sense.
- Invest: if you have a viable business idea and plan you can finance it using the proceeds from a cash-out refi.
- Pay expenses: whether you’re struggling with utility bills, education expenses, or healthcare, the money from a cash-out refi can be of help.
- Make a large purchase: some things like cars require more money than you can save from just your salary. The funds from a cash-out refi can go a long way in helping you complete such purchases.
Reasons to Consider a Cash-Out Refinance
A cash-out refinance comes with plenty of benefits when done correctly and at the right time. Top of the list is the fact that you get to refinance your mortgage. You will enjoy lower interest rates and potentially favorable lending terms from the lender.
Secondly, a cash-out refinance will make cash available to you. You can use the money for debt consolidation, emergency expenses, or home improvements among many other things. Either way, it is a reasonable way of staying afloat during hard financial times.
Also, when you use the money from a cash-out refi to pay down/off some of your high-interest debts (particularly credit card), you will improve your credit score. That puts you in a good place to get a better line of credit in future.
Although a cash-out refinance is undoubtedly beneficial for anyone in need of cash, it does have some potential drawbacks. For starters, you will be tapping into the home’s equity. That means the home’s loan-to-value (LTV) ratio will increase.
Ideally, you want to keep that value as low as possible so as not to compromise your ownership of the property. The higher it goes, the bigger the risk of foreclosure if you fail to make mortgage payments.
There are also closing costs that might make your cash-out refi more expensive than you initially thought. They typically add up to 3 to 6% of the value of the mortgage. That’s about $6,000 – $12,000 for a $200,000 mortgage. If you roll them into the loan, they will increase the total amount on which interest is charged. You might end up paying a lot more that you would if you hadn’t refinanced. Depending on the type of loan and your financial standing, you may also be asked to pay private mortgage insurance (PMI).
Another thing that can increase the overall value of the loan is the interest rate. Usually, you’re only allowed to refinance if you can get a lower rate. While that may reduce your monthly payments, it may come with an elongated term, which in turn may increase the overall amount of the loan. The trick is to know how much of a drop in interest rate is enough to warrant a financially sensible refinance.
Our mortgage experts at Mortgage Right can help you determine whether it is the right time to consider a cash-out refinance. It doesn’t matter the type of loan you have; we will advise you on the best way to go about refinancing and even help you get the best cash-out refinance.