What is a Cash-Out Refinance?
In a cash-out refinance, the homeowner exchanges their current mortgage with a new one that has a higher principal balance (but, usually, more favorable terms and/or a lower interest rate). The key feature of a cash-out refinance is that the homeowner receives a portion of the home's equity in the form of cash during the refinancing process. This so-called “cash out” can be used for a multitude of purposes, from home renovations to debt consolidation.
How Does a Cash-Out Refinance Work?
- Assess Home Equity: The first thing the homeowner does is to determine the amount of equity in the home. (“Equity” is the difference between the current market value of the home and the outstanding mortgage balance).
- Loan Application: The homeowner then applies for a new mortgage that is larger than the current one, which will reflect the desired cash-out amount. During the process, the lender will assess their creditworthiness, income, and other financial factors, to determine eligibility and terms.
- Appraisal: Next, the lender will typically require a home appraisal to determine the current market value of the property. The amount you can cash out is usually limited to a percentage of the home's appraised value–often, around 80-85%.
- Approval and Closing: This is the step in which the homeowner receives the funds. Once approved, the new mortgage is finalized, and the existing mortgage is paid off. Then the homeowner receives the cash difference between the new mortgage amount and the old mortgage balance (and any closing costs if they are paid out of the new mortgage).
- Repayment: Just as with the original mortgage, the homeowner will make regular monthly payments on the new, larger mortgage. Note: this now includes both the existing mortgage balance and the cash-out amount.
- Use the Funds: Meanwhile, the homeowner is free to use the funds at their leisure.
Some notes: A cash-out refinance may have associated costs, including closing costs and fees. Additionally, increasing the mortgage balance can extend the time it takes to pay off the home, which can result in higher overall interest costs. Interest rates on cash-out refinances are typically in line with current mortgage rates.
What are the Requirements for a Cash-Out Refinance?It’s important to note that each individual lender will have their own host of requirements surrounding eligibility for a cash-out refinance. However, here is some common criteria:
- Sufficient Home Equity: You typically need a minimum amount of equity in your home to qualify for a cash-out refinance– usually, at least 20% to 25% after the refinance. This means that your loan-to-value (LTV) ratio should generally be no higher than 80-85%. The LTV ratio is calculated by dividing the new loan amount by the appraised value of your home.
- Good Credit Score: Though the specific credit score can vary, a score in the range of 620 to 680 (or higher!) is often preferred. Plus, a higher credit score may also help you qualify for more favorable interest rates.
- Stable Income & Employment: Since you will be responsible for making monthly mortgage payments, the lender will want to make sure that this is something to which you can commit. You'll typically need to provide proof of steady employment or income through pay stubs, tax returns, and other documentation.
- Debt-to-Income Ratio: Lenders assess your ability to manage additional debt by calculating your debt-to-income ratio. This ratio compares your monthly debt obligations to your gross monthly income. Lenders often have maximum allowable DTI limits, typically around 43% to 50% of your gross income.
- Payment History: Naturally, lenders want to know that you will pay them on time. They will look at your payment history to verify that you have set such a precedent. Late payments, defaults, or other negative marks on your credit report can hinder your eligibility.
- Documentation: You'll need to provide various documents to support your application, including bank statements, tax returns, W-2 forms, and other financial records. Be prepared to thoroughly document your income and assets.
- Occupancy: Some lenders may have different requirements for second homes or investment properties, but usually you will need to live in the home as your primary residence.
Pros of a Cash-Out RefinanceA cash-out refinance can have several benefits, depending on your particular needs and circumstances.
- Access to Cash: The most obvious advantage is that you can access a significant amount of cash by tapping into your home equity in this manner. As mentioned, you can use the funds for just about anything, such as home improvements, debt consolidation, investments, education expenses, or emergency funds.
- Lower Interest Rates + Simplified Finances: Mortgage interest rates tend to be lower than rates on unsecured debt. So, if you're currently paying a high interest rate on other debts, like credit cards or personal loans, a cash-out refinance can help you consolidate these debts into your mortgage. Consolidating high-interest debts into your mortgage can streamline your monthly finances by reducing the number of creditors and payments you need to manage. Plus, you could potentially secure a lower overall interest rate.
- Tax Deductions: In some cases, mortgage interest may be tax-deductible. (This depends on your individual circumstances and tax laws in your area).
- Home Improvement: If you use the cash-out funds for home renovations or improvements, you might increase the value of your home. Doing so would make it a wise investment in the long run.
- Fixed Interest Rate: If you have an adjustable-rate mortgage (ARM), a cash-out refinance can allow you to switch to a fixed-rate mortgage, providing more stability in your monthly housing costs and improving your ability to construct long-term budgets.
- Extended Repayment Term: A cash-out refinance can extend your mortgage term. While this can be beneficial, as it may lower your monthly payments, it also increases the total interest paid over the life of the loan.
- Flexibility: You have the flexibility to use the cash however you’d like, whether it's for short-term financial needs or long-term investments.
- Improve Credit Score: Paying off high-interest debts through a cash-out refinance can positively impact your credit score over time if you are enabled to make consistent mortgage payments.
Cons of a Cash-Out RefinanceThough the benefits may sound appealing, don’t forget to weigh the other side of the coin. Cash-out refinances also have some downsides.
- Increased Mortgage Debt: A cash-out refinance increases the principal balance of your mortgage, which means you'll owe more money on your home. When the new mortgage extends the life of your loan, it also likely increases the total interest paid over the life of the loan.
- Higher Monthly Payments: Depending on both the terms of the new mortgage and the size of the cash-out amount, your monthly mortgage payments could significantly increase. As a result, you may find your monthly budget severely strained.
- Risk of Foreclosure: Failure to make your monthly mortgage payments can result in the loss of your home through foreclosure.
- Closing Costs: Just like with any regular mortgage transaction, there are closing costs associated with a cash-out refinance. These costs can include loan origination fees, appraisal fees, title insurance, and other expenses.
- Resets the Mortgage Clock: If you've been making payments on your current mortgage for a significant period, you might not be pleased that a cash-out refinance essentially resets the clock on your loan. This means you'll be back to making primarily interest payments in the early years of the new mortgage.
- Risk of Overleveraging: Accessing too much of your home equity can lead to overleveraging, where you owe more on your home than it's worth. This is especially likely If property values decline; you may find yourself in a situation where you have negative equity, which makes it hard to sell or refinance your home.
- Potential for Decreased Home Equity: In line with the above risk, one con is that you reduce the amount of equity you have in your home. This can affect your ability to access funds for other needs in the future, such as selling the home or using it as collateral for another loan.
What is a home equity loan?
A home equity loan is often referred to as a second mortgage. As you might deduce from the name, it is a type of loan that allows homeowners to borrow money by using their home's equity as collateral.
What is the process for a home equity loan?
- Check Your Credit Report & Calculate Your Home Equity: Obtain a copy of your credit report and review your credit history, ensuring its accuracy. This is important because a good credit score can help you qualify for better loan terms. Additionally, you should determine the amount of equity in your home by subtracting your mortgage balance(s) from the current market value of your home. Lenders typically require 20% to 25%, to qualify for a home equity loan.
- Research Lenders: Be sure to compare terms and rates between various lenders, from traditional banks and credit unions, to online lenders.
- Complete Application: Submit a loan application with the lender you choose. You'll need to provide personal and financial information, including income, employment history, and details about your existing mortgage(s).
- Receive a Home Appraisal: The lender will typically require a professional appraisal of your home to determine its current market value, as the amount you can borrow will depend on the appraised value and the lender's loan-to-value (LTV) ratio requirements.
- Underwriting Approval: Next, the lender will review your application, credit history, and the appraisal, to assess your eligibility and determine the loan terms. Know that you may be asked for additional documentation or information during this process, and that the longer you take to provide it, the more delays you will incur.
- Loan Approval & Disclosure Documents: If your application is approved, the lender will provide you with a loan approval letter and a set of disclosure documents that detail the loan terms, interest rate, closing costs, and other important information. Review these closely and ask the lender any questions you may have.
- Schedule the Closing: Once you understand and are satisfied with the terms and have reviewed all documents, schedule a closing date with the lender, during which time you'll sign the final loan agreement and other required paperwork.
- Receive the Funds: After the closing, the lender will disburse the loan funds to you as a lump sum payment, and you can use them however you’d like.
- Repayment: Begin making monthly payments according to the terms of the loan, including the principal and interest.
What are the Requirements for a Home Equity Loan?
Just as with the cash-out refinance, you should be aware that requirements vary from lender to lender. Some of the more common criteria, however, are:
- Sufficient Home Equity: As previously mentioned, you must have a significant amount of equity in your home. Most lenders require that you have at least 20% to 25% equity remaining in your home after taking out the home equity loan. This means your loan-to-value (LTV) ratio should typically not exceed 80-85%, though this depends on the lender's requirements.
- Good Credit Score: Lenders typically look for a solid credit score. A credit score in the range of 620 to 680 or higher is often preferred, but, once again, requirements can vary among lenders.
- Stable Income and Employment: You'll need to provide proof of steady employment or income through pay stubs, tax returns, and other documentation so that the lender can see that you will be able to make your monthly payments.
- Debt-to-Income Ratio (DTI): Lenders assess your ability to manage additional debt by calculating your debt-to-income ratio. The DTI tends to be limited to a certain percentage of your gross monthly income, often around 43-50%.
- Clean Payment History: A good payment history on your existing mortgage and other debts is crucial. Late payments, defaults, or other negative marks on your credit report can seriously hinder your eligibility, as it suggests to the lender that you are unreliable.
- Property Occupancy: Home equity loans are usually only available for primary residences, though some lenders may have separate requirements for second homes or investment properties.
- Documentation: You'll need to provide various documents to support your application, including bank statements, tax returns, W-2 forms, and other financial records.
- Appraisal: As previously mentioned, most lenders require a professional appraisal of your home to determine its current market value.
- Loan Purpose: Lenders may inquire about the purpose of the loan, and some may have restrictions on how you can use the funds. This is not universally the case, however.
Pros of a Home Equity Loan
- Access to Funds: The obvious benefit of a home equity loan is that it allows you to tap into the equity you've built up in your home, providing you with a lump sum of money that you can use for various purposes, such as home improvements, debt consolidation, or other major expenses.
- Fixed Interest Rate:Usually, home equity loans have fixed interest rates, which means your monthly payments remain consistent over the life of the loan. This predictability can make budgeting easier.
- Lower Interest Rates: Home equity loan interest rates are also often lower than rates on unsecured loans, like personal loans or credit cards, because the loan is secured by your home's equity.
- Potential Tax Deductions: In some cases, the interest paid on a home equity loan may be tax-deductible– especially if the loan proceeds are used for home improvements. Consult a tax professional to understand the tax implications in your particular situation.
- Flexible Use of Funds: You have the flexibility to use the loan proceeds for a wide range of purposes, which allows you to address various financial needs and meet a myriad of goals.
- Structured Repayment: Home equity loans come with fixed monthly payments and a set repayment term, making it easier to plan and manage your debt.
- No Impact on Existing Mortgage: A home equity loan doesn’t affect your existing mortgage. It's a separate loan, so you can use the funds without needing to refinance your primary mortgage.
- Interest-Only Option: Some lenders offer interest-only home equity loans, where you can make interest-only payments for a certain period before starting to pay down the principal.
- Availability for Various Credit Profiles: While good credit can help you secure better terms, some lenders are more lenient in their credit requirements for home equity loans, especially compared to other types of loans.
Cons of Home Equity Loans
- Risk of Losing Your Home: Although the fact that your loan is secured by your home leads to some benefits, it is also a huge risk. If you default on the loan, you could potentially lose your home through foreclosure.
- Additional Debt: A home equity loan adds another debt obligation to your financial portfolio. If you struggle with monthly payments, this addition could make your debt load too heavy to manage.
- Closing Costs: Just like with a primary mortgage, home equity loans typically involve closing costs, which can include loan origination fees, appraisal fees, and other expenses.
- Interest Costs Over Time: While home equity loan interest rates are often lower than rates on unsecured debt, the total interest paid over the life of the loan can really add up if the loan term is long.
- Reduced Home Equity: This may seem obvious, but by borrowing against your home's equity, you reduce the amount of equity you have in your property. This can affect your ability to access funds for other needs in the future or to sell your home at a profit.
- Potential for Overleveraging: Accessing too much home equity can lead to overleveraging, where you owe more on your home than it's worth. If property values decline, this can be detrimental, as it may limit your options if you need to sell the property.
- Risk of Interest-Only Payments: Some home equity loans offer an interest-only payment option for a certain period. While this can lower your monthly payments in the short term (a pro), it can also lead to a larger unpaid balance that you must repay later (potentially a huge con).
- Impact on Credit Score: Defaulting on a home equity loan will have a negative impact on your credit score, likely making it harder to secure credit in the future.
- Loan-to-Value Ratio (LTV) Limits: Lenders typically have maximum allowable LTV ratios, which can limit the amount you can borrow based on your home's appraised value. If you need to borrow a significant amount, you may not qualify for the full amount you desire.
Similarities Between Cash-Out Refinances & Home Equity Loans
You’ve probably already noticed some obvious similarities between the cash-out refinance and the home equity loan. It makes sense; they are both ways to tap into your equity. Let’s take a closer look at what else they have in common:
- Equity as Collateral: As mentioned, both cash-out refinances and home equity loans enable homeowners to tap into the equity they have built up in their homes. The equity is used as collateral for the loan, allowing borrowers to access a lump sum of money.
- Secured Loans: Both types of loans are secured by the borrower's home. This means that if the borrower defaults on the loan, the lender has the right to foreclose on the property in order to recover the debt.
- Fixed Interest Rate Option: Home equity loans usually come with fixed interest rates, and cash-out refinance loans can also have fixed interest rates. This means that borrowers have predictable monthly payments over the life of the loan, and tends to be the more desirable option for that reason.
- Tax Deductibility: In many cases, the interest paid on both cash-out refinance loans and home equity loans may be tax-deductible, depending on various factors–for example, how funds from the loan are used. Consult a tax advisor to be sure whether this might be the case for you.
- Closing Costs: Both types of loans typically involve closing costs, which can include loan origination fees, appraisal fees, and other expenses. These costs can add to the overall expense of the loan and are important to consider.
- Loan-to-Value Ratio (LTV): Lenders assess the loan amount based on the home's appraised value and the borrower's existing mortgage balance. Both cash-out refinance loans and home equity loans have LTV ratio limits, though their precise amounts may vary among lenders.
- Fixed Loan Terms: Home equity loans often come with fixed repayment terms, and cash-out refinance loans can also have fixed terms. Borrowers are required to make regular monthly payments over the specified term until the loan is paid off.
Differences Between Cash-Out Refinances & Home Equity Loans
Though both cash-out refinances and home equity loans clearly have quite a bit in common, they also entail many differences.
- Loan Structure: With a cash-out refinance, you receive a lump sum of money upfront, which includes the amount you're borrowing in addition to paying off your existing mortgage. A home equity loan also provides a lump sum of money upfront, but it is separate from your existing mortgage. Instead, you continue to make payments on both your primary mortgage and the home equity loan.
- Interest Rates: Cash-out refinances can have lower interest rates compared to home equity loans because they are first position mortgages, which are typically considered less risky for lenders.
- Monthly Payments: Cash-out refinance monthly payments include both the existing mortgage balance and the additional cash-out amount, whereas home equity loans have separate payments from the existing mortgage.
- Closing Costs: While both cash-out refinances and home equity loans have closing costs, those of the latter might be lower.
- Loan Process: The process for a cash-out refinance involves applying for a new mortgage, getting an appraisal, and going through the approval and closing process as you would for any mortgage. On the other hand, the process for obtaining a home equity loan tends to be simpler and quicker, with fewer steps involved.
Should I Apply for a Cash-Out Refinance or a Home Equity Loan?The decision between a cash-out refinance and a home equity loan depends on your specific financial goals, circumstances, and preferences. As you’ve already seen, both options have pros and cons. There isn’t a universal one-size-fits-all option. Here are a few things for you to think about if you’re trying to decide between the two:
Interest Rates: Compare the interest rates available for both options. If you can secure a lower rate with a cash-out refinance, for example, it may save you money in the long run.
Loan Amount: Consider how much money you need. Home equity loans may be a better choice for smaller loan amounts, while cash-out refinances are suitable for larger amounts.
Loan Term: Determine your preference for the term of the loan. If you want a shorter-term loan with more predictable payments, a home equity loan might be better. If you're open to extending your mortgage term, a cash-out refinance could be a good fit.
Financial Goals: Consider your overall financial goals. Are you looking to reduce monthly payments, consolidate high-interest debt, or fund a major project? Assess how each option aligns with your objectives.
Risk Tolerance: Although it may feel extreme, determine your comfort level with the potential risk of losing your home. A home equity loan does not impact your primary mortgage, while a cash-out refinance increases your primary mortgage debt.
Tax Implications: You should consult a tax advisor to understand the potential tax benefits or consequences of each option based on your intended use of the funds.
A Unique Alternative to a Cash-Out Refinance
While you’re conducting research on the best way to extract equity from your home, don’t overlook the equity sharing agreement option. Unison pioneered the equity sharing agreement and has helped over 10,000 homeowners in 30 states stop sitting on their home equity and put it to work! With a Unison equity sharing agreement, homeowners don’t have to worry about adding to their monthly payment obligations, and there is no interest, either. Instead, Unison gives the homeowner up to 15% of the value of their home in cash, in exchange for a percentage of the home’s future change in value at the end of the agreement. Significantly, there is no added debt; you can live the life that you’ve always wanted without being haunted by interest rates or monthly payments.
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