Here’s, briefly, how a cash-out refinance works:
Current Mortgage: This is where you start– you have an existing mortgage on your home with a remaining balance.
New Mortgage: Then you apply for a new mortgage with a higher loan amount than your current mortgage. The new mortgage pays off the existing one–and provides you with additional funds.
Cash Disbursement: The difference between the new mortgage amount and the old mortgage balance is given to you in cash at closing. (This is the “cashing out”).
Repayment: Ta-da! You then repay the new mortgage over time, typically with a fixed or adjustable interest rate and monthly payments.
Homeowners commonly use cash-out refinances for various purposes, such as home improvements, debt consolidation, or investing in other opportunities. The cash-out refinance in particular can be appealing in situations where the homeowner can take advantage of lower mortgage interest rates while accessing the equity they've built in their homes.
Of course, the first step in the process of any big financial decision should be to research your choices! If you’re looking for the best method to tap into your growing home equity and make it work for you, read on to see the benefits and the drawbacks of a cash-out refinance.
Pros of a Cash-Out Refinance
Let’s start with the good stuff.
Lower Interest Rates
Check out the current mortgage interest rates. Are they lower than the rate you’re paying for your present mortgage? A cash-out refinance would allow you to not only replace that mortgage with a new one and take the difference in cash, but also secure the more favorable terms. Say hello to lower monthly payments and long-term interest savings!
When you opt for a cash-out refinance, you can potentially secure a larger loan amount than what is typically available through alternative borrowing methods, especially such as personal loans or credit cards.
Tax-wise, there’s some good news with a cash-out refinance: the cash you take out of your equity during the transaction isn't considered income by the IRS. On top of this, depending on how you use the loan proceeds, a cash-out refinance might qualify you for a tax deduction, too! If you apply the funds to a renovation project that increases the value of your home (called “capital improvements”), you can deduct the interest of your loan.
Longer, More Predictable Payment Period
For the most part, homeowners who obtain a cash-out refinance do so with a 30-year fixed-rate mortgage. Just as with a regular mortgage, you will know how much your monthly payments will be; the interest cannot change. That’s not the case with many other choices for tapping home equity, such as HELOCs.
Cons of a Cash-Out Refinance
It’s important to note the drawbacks to any potential alternative–let’s do that next.
High Interest & Closing Costs
While a cash-out refinance can be a boon if interest rates are low, the opposite is true when interest rates are high! You wouldn’t want to replace your current mortgage with a new one if the terms were less favorable. In addition, be aware that there are closing costs that add to the overall expense of the loan, including application fees, appraisal fees, title insurance, and other expenses.
Don’t forget that if you struggle to make the new, higher mortgage payments in a cash-out refinance, your home is serving as collateral for the loan! This could put you at a serious risk for foreclosure.
Decreases Your Home Equity
When you take out a cash-out refinance, you’re replacing your previous mortgage with a brand spanking new one. As a result, you’re erasing the equity you built up and starting from scratch. You won’t be able to tap into that equity for quite some time, and if you should sell your home, you will receive much less of a financial benefit.
Longer Closing Times
A cash-out refinance is not a great choice if you need the funds in a timely fashion–closing times tend to be longer than other equity products.
Should I Get a Cash-Out Refinance?
At the end of the day, you’re the only one who can really decide whether an alternative is best-suited for you and your unique situation. And if you have a financial advisor, you should certainly consult with them, too. However, generally speaking, a cash-out refinance may be a good idea if:
- you qualify for better terms (i.e. lower interest rates)
- you intend to use the funds for capital improvements (as discussed above)
- you want to consolidate high-interest debt, as a cash-out refi could lower your overall interest costs and simplify your debt management
On the other hand, a cash-out refinance may not be a good idea if:
- your credit score is low (which will prohibit you from obtaining favorable terms)
- you plan to sell your home soon (as the lost equity will prevent your making any profit)
- it comes with unreasonable closing costs
- you’re tapping into your equity to meet short-term financial goals, such as covering everyday expenses or vacations; you may end up paying for these expenses over the long term with interest!
Frequently Asked Questions About Cash-Out Refinance
How Much Are Cash-Out Refinance Closing Costs?
The closing costs for a cash-out refinance can vary widely based on several factors, such as your location, the chosen lender, the loan amount, and the specific terms of your refinance. On average, closing costs for a cash-out refinance (typically) range from 2% to 5% of the total loan amount. But you may also be responsible for some of the following:
- Origination Fees: cover the lender's administrative costs for processing your loan application
- Appraisal Fee: An appraisal of your property is typically required to determine its current value.
- Credit Report Fee: As part of the underwriting process, lenders often charge a fee to pull your credit report.
- Title Search and Title Insurance: cover the cost of researching the property's title history and providing insurance to protect against title issues
- Recording Fees: When your new mortgage is recorded with the county or municipality, there are associated fees.
- Homeowners Insurance: Lenders may require you to prepay a portion of your homeowners insurance as part of the closing costs.
- Property Taxes: Depending on your loan and the timing of your refinance, you may need to pay property taxes upfront.
- Attorney or Escrow Fees: In some states, an attorney or escrow company may be involved in the closing process, and their fees can be included in the closing costs.
- Courier Fees: These fees cover the cost of sending documents between parties involved in the transaction.
How Much Money Can You Get With a Cash-Out Refinance?
The amount of money that you can obtain from a cash-out refinance is dependent on multiple factors, such as the current value of your home, the outstanding balance on your existing mortgage, the loan-to-value (LTV) ratio allowed by your lender, and the specific terms of the refinance.
Most lenders allow a maximum LTV ratio of 80% to 85% for cash-out refinances. This means that the new loan amount, including the cash you receive, cannot exceed 80% to 85% of your home's current appraised value. If you subtract the outstanding balance on your existing mortgage from the maximum loan amount, you should have a decent idea of the “cash out” for which you will be eligible.
Can I Refinance My Home Without Taking Cash Out?
You can refinance your home without taking cash out; such a refinance is commonly referred to as a "rate and term refinance" or a "no cash-out refinance." In a rate and term refinance, the primary goal is to obtain a new mortgage with more favorable terms, such as a lower interest rate or a different loan term, without tapping into your equity.
A Unique Alternative to Cash-Out Refinance
If you want to access your equity, but aren’t sure that a cash-out refinance is quite right for you, you should consider a Unison equity sharing agreement. Like a cash-out refinance, a Unison Agreement enables you to dip into the funds trapped in your home so that you can use them to live the life you want. However, unlike a cash-out refinance, a Unison Agreement doesn’t require monthly payments or accrue interest. Instead, Unison gives you up to 15% of your home’s current value in cash in exchange for an agreed upon percentage of your home’s future change in value at the end of the agreement. Unison has helped over 10,000 homeowners to access their equity and achieve their financial goals, whether by saving for retirement, renovating their homes, or starting a new business venture. If you want to tap into your equity, but don’t want to mess with interest rates, get a free estimate today with zero obligation or effect on your credit score and see whether Unison might be a good fit for you!