Cash-Out Refinance: What Is It and How Does It All Work?

Are you looking to refinance your home loan? If so, then you may be looking into doing what’s called a cash-out refinance.

These mortgages allow you to borrow money, as well as refinance the loan. Once you close, you’ll be given a check.

How do these mortgages work, and is it the right option for you? Let’s take a look.

How Does a Cash-Out Refinance Work?

There are several reasons why you may want to get a cash-out refinance. The money you borrow can be for various things, such as paying off medical debt or doing repairs on the home itself.

Typically, there are no restrictions on what the money can be used for. You just need to have the right amount of home equity to borrow it.

Essentially, when you take out this home loan, you’re taking out some of the money you’ve paid into it and increasing the mortgage principal owed. So it works as a combination refinance and home equity loan.

Qualifying for a cash-out refinance loan

Will you be able to qualify for this loan?

You’ll need a certain amount of home equity to borrow against. For example, if your home is worth $250,000, and you owe $150,000 on the mortgage, that gives you $100,000, or 40% home equity.

When you refinance, you’ll want to retain at least 20% of the home’s equity. In this case, you’ll be able to borrow $50,000 against your home’s equity.

To get exact numbers, you’ll need to shop around and talk to lenders. Some lenders will allow you to go lower than 20%, but you’ll need to consider if that is for you.

If you want to go ahead with the loan, you’ll need to take out a new mortgage at $200,000. This covers the $150,000 owed, as well as the $50,000 you’re borrowing.

Once you do this, you’ll get a check for $50,000 at closing. Be aware; this doesn’t take into account closing costs, which are usually around 3 – 6% of the mortgage cost and are often rolled into the mortgage itself.

Once you have that new loan, you’ll continue paying it off as you were before. But, then, you have that money you borrowed to use as you see fit.

The Pros And Cons Of A Cash-Out Refinance

Now you know how a cash-out refinance works, you need to think about if it’s for you. Is it the right option when you need a loan?

Here are the pros of a cash-out refinance:

  1. Put that equity to use
  2. Use the loan money as needed
  3. Lower rates
  4. Longer repayment time frames
  5. Tax-deductible interest
  6. Reduce your mortgage rate
  7. Improve your credit score

Put that equity to use

If you’ve built up some good home equity, then you can put it to use this way. Cash-out refinance loans are great as you can use that money you put into the loan to borrow again, should you need the money.

Use the loan money as needed

As mentioned above, you can use the money you get from the loan however you wish.

There are usually no restrictions, so you can use them as needed. As mentioned above, many use it to fund repairs to the home itself.

Whatever you need the cash for, you can borrow against your home equity and use it.

Lower rates

One of the best benefits of a cash-out refinance loan is that it typically has lower interest rates than other loans. This way, it’s highly cost-effective as a way of borrowing cash when you need it.

That’s why a lot of people use these loans to pay off other debts, such as credit card debt or a home equity loan. This way, they’re actually lowering the interest rates on those debts.

Longer repayment time frames

Another good reason to refinance your home is that you get a longer repayment window. Depending on the lender you go with, you can get up to 30 years to repay.

That’s another good reason to use the loan to repay other debts. For example, if you have debts that need to be paid in 5 – 10 years, you can pay them back with this loan and have much longer to repay the money.

Tax-deductible interest

What’s interesting about cash-out refinance loans is that they’re typically tax-deductible. This is because the interest on the loan is what you can deduct, and so you’ll be able to deduct it from your taxes up to a certain limit.

If you have other debt, rolling it all into this loan means you’ll be able to deduct the interest on all of it. You’ll need to speak to your lender to find out more, but it could be highly useful for you.

Reduce your mortgage rate

Mortgage rates change all the time, and that means that rates may have dropped since you took out the original loan on your house.

That doesn’t mean that you have to keep paying those high rates. If you want to reduce the rate on it, you can look into a cash-out refinance loan.

When you take out the new loan, you’ll be borrowing at the new rates. That way, you can borrow money and get a better rate at the same time.

Improve your credit score

Are you looking to improve your current credit score? Then a cash-out refinance loan could be just what you’re looking for.

This happens when you pay off other debt, such as credit card debt, with the payout from this loan. As you pay them off, you’ll reduce your debt utilization ratio.

When you do this, you’ll be a more attractive proposition to lenders in the future. So that’s always good to do, in case you need that credit in the coming years.

Cash-out refinance cons

Foreclosure risks

Remember that your home is the collateral for any kind of mortgage. If you’re unable to make the payments on that loan, then you risk losing it.

Lenders tend to frown upon using a cash-out refinance loan to pay off debt such as credit card debt. This is because you’re paying off an unsecured loan with a secured loan.

This is not popular with lenders as there’s the risk of losing your home. So do the math, and ensure you’ll be able to make the repayments if you choose to go ahead with the loan.

New terms

As you’re taking out a new home loan, there will be new terms that you need to agree with. However, as noted in the pros section, these could actually be a boon, such as lower interest rates.

However, they may not always be to your liking. You may not be able to find terms that are as good as the terms you have on your current mortgage.

This is why it pays to shop around first. Pay close attention to the terms, and see what you’re getting.

Closing costs

Remember that those closing costs will be included when you refinance your home loan, as they would be with any loan. So in the above example, you’ll be paying $6000 minimum in closing costs.

Because of this, the savings you’re making on your new loan aren’t going to be as high as you think they are. So again, you need to check the terms carefully before you sign on the dotted line.

You may not get quite what you were looking for here, so make sure you know the closing costs before you agree to a new loan.

Private mortgage insurance

Depending on how much you borrow, you may find that you have to pay private mortgage insurance on your new loan. Again, if your home is valued at $200,000 and you borrow more than 80% of it, then you’ll have to pay that PMI.

Private mortgage insurance usually accounts for 0.55% to 2.25% of your loan amount each year. So you’ll need to consider if paying that extra cost is worth it in the long run.

Running up debt again

If you’re using the refinance loan to pay off credit cards, there’s always the temptation to simply run them up again. You need to be certain that you’ll be able to keep them clear for as long as you have them.

There is the option to close the credit cards as soon as you’ve cleared the balance on them. But, of course, you need to ensure you don’t take out other lines of credit as soon as you do, as you’re looking to reduce your debt overall.

There are plenty of pros and cons to getting a cash-out refinance loan, and you’ll need to decide if it’s worth it to you. Every home owner’s situation is different, so you’ll need to think about if it’s the right option for you.

Are There Alternatives To A Cash-Out Refinance?

You’ve seen what cash-out refinance loans are and how they work. They’re a good option if you’re looking to take out a loan, but are there other options for you.

It’s always a good idea to know exactly what’s out there for you. Here are some other options that you may want to consider

Remember, you can always talk to a lender and get their opinion, too, so make sure to do that when considering a cash-out refinance loan.

Home equity loan

When you need to borrow money, you may not need as much money as you’d get in a cash-out refinance loan. In this case, you can go with a straightforward home equity loan.

Again, these funds can be used for anything you need them for. For example, they can be used for home improvements, college tuition, and so on.

These are often cheaper than a cash-out refinance loan, as there are cheaper closing costs, and you only pay interest on the credit used. They also have more flexibility, so they may be the right loan for you.

Personal loan

This is the most common type of loan to get when you’re in need of some extra cash. These are again usable for all kinds of expenses, and the costs are typically lower than a cash-out refinance loan.

Instead of paying over 15 – 30 years, you’ll typically pay off a loan in around 5 years. If you have a good credit rating, you should be able to get a good interest rate on it, too.

One of the benefits here is that there are a lot fewer hoops to jump through, and you’ll find that you can get the funds in just 24 hours. So that’s going to work well for you if you need the money quickly.

Also, consider that adding another line of credit may actually improve your credit score. That’s good to know if you’ve had issues in the past and want to improve your credit.

Refinancing and adding a second mortgage

You also have the option to refinance the mortgage you already have and then put a second mortgage on your home. This allows you to get many of the same benefits of a cash-out refinance loan.

In some cases, it could be cheaper to get the refinanced loan and then add a second mortgage to your home. Instead, you can go for a fixed home equity loan, good for lump sums, or a HELOC if you need more flexibility.

It’s always best to ask your lender what they would recommend to you in your situation.

Find other sources of cash

If you are in need of extra cash, then a traditional loan may not be the best option for you. You’ll need to weigh up the costs carefully and see if they’re the best route for you.

If not, there are other ways of making that needed cash. For example, you can sell off any luxury items you have, borrowing from family, or generating more income through side hustles.

A cash-out refinance loan may be just what you need to obtain a loan. If you want to borrow against the equity in your home, then it could be right for you.

Use this guide to weigh up the pros and cons and see if it’s going to work for you. Then, talk to a lender, and you can get started with your loan.

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