A cash-out refinance taps into the equity of your home. This is money left over in the value of your home after you subtract your current mortgage amount. Whether your home appreciated or you paid your current loan down, you have equity.
The equity is yours to use, up to a certain extent. Many lenders offer the ability to take cash out of the home for many reasons. Be open and honest with your lender to find the right solution for you. Here we help you decide if the cash-out loan is the right choice.
How the Cash-Out Refinance Works
A cash-out refinance works differently than a standard refinance. With a standard refinance, you borrow the amount of outstanding principal. You don’t take any extra money out. When you take cash out, you refinance the outstanding principal, plus the amount of equity you are eligible to receive. The amount you can borrow varies by program and lender. Generally, lenders allow no more than 85% of your home’s equity. Some lenders may grant exceptions.
No matter how much you borrow, the process works the same:
- The lender pays off your existing mortgage
- The lenders gives you the excess cash in one lump sum
- You start making payments on the full amount (principal and interest payments)
The amount of equity you have in the home varies. You will need a new appraisal to determine your home’s value. If your home appreciated since you purchased it, you may have more equity than just what you paid off with your mortgage.
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Reasons to Take Cash Out of Your Equity
Borrowers take cash out of the equity for a variety of reasons. Home improvements top the list. However, borrowers take money out for a variety of other reasons including:
- Pay off debt
- Pay for college
- Fund a vacation
- Pay for a medical emergency
- Pay for unexpected household emergencies
Lenders are often the most concerned when you use the money to pay off debt. Your debt ratio plays a large role in the approval process. If you pay off debt, your debt ratio may lower. In this case, though, the lender may not disburse the extra funds to you. Instead, they pay your debtors off directly. This way they know you don’t owe the debts anymore. If they disburse the funds to the borrower, the debts may not get paid. Then the borrower ends up with a higher debt ratio and a higher risk of default.
Is it Right For You?
Now you know reasons to take a cash-out refinance. But, is it right for you? Here’s how to decide:
- Is the interest rate on the cash-out loan equal to or lower than your current rate? If it’s higher, it may not be the right choice.
- What will you use the funds for? Is it for a long-term purpose, such as home improvements? Or is it something shorter term, such as funding a vacation? Remember, you stretch the payments out over 20-30 years. A vacation isn’t worth paying for that long. Housing improvements may be a better option for this loan though.
- Can you comfortably afford the payments? If you aren’t sure, don’t put your home at risk. Too many late payments and you could lose your home.
Benefits of a Cash-Out Refinance
A cash-out refinance has several benefits including:
- A possible lower interest rate than you pay on other debts. Credit card debt, personal loans, and even home equity loans may have higher interest rates. A loan with first lien position often has lower rates because of the collateral it holds.
- Your credit score may increase if you pay off debts. Too many debts and outstanding balances negatively affect your credit score. Paying the debts off with your mortgage can help your score increase.
- Mortgage interest on a first mortgage is tax deductible. Talk to your tax professional to make sure this applies to you, though. This may mean a lower tax liability in the future.
The Disadvantages of a Cash-out Refinance
Refinances taking cash out of your equity may have downsides too:
- You put your home at risk. Your home is the collateral for a cash-out refinance. Don’t get in over your head with financing. Make sure you can afford the payments. If you default, you put your home at risk.
- You could reset your loan term. Watch the term you take on the new loan. Think of how many years you already paid on your current mortgage. You don’t want to reset the payments at square one. For example, if you had a 30-year term and paid 10 years already, try a 20-year term. Again, make sure you can afford the payments.
- You must be financially responsible. If you use the cash-out loan for debt consolidation, you must not charge up your cards again. Getting yourself back in debt only doubles your debts. This could put your home at risk again.
Write down the pros and cons of a cash-out refinance to see if it’s right for you,. Think of your situation. Also, write down your current budget. Then write down the reasons for the cash-out. Are they long-term or short-term needs? Are there other ways to fund what you need? If so, what are the rates and costs? These answers can help you determine the right answer.
The cash-out loan has many benefits if you take it for the right reasons. If you overextend yourself, though, you could end up in financial trouble. Carefully considering your options and shopping around helps the most. Lenders must provide you with a Loan Estimate within 3 days of applying for a loan. This shows you the interest rate, potential payment, and costs of the loan. You can then compare the estimates side-by-side. Figure out which loan suits your needs the most and take advantage of the money you have in your home’s equity.