If you are a homeowner who’s lived in your home for more than a year or two, you might have built up some equity that you could tap into. It’s not always a good idea to use your home equity, but if you do need to use it, a cash-out refinance will be one possible option for you.
Before making a decision either way, you should research all possible financing options and see which one serves your needs the best. Below, we help you understand how a cash-out refinance works and when it may or may not be a good idea.
What is a Cash-Out Refinance
A cash-out refinance is essentially a new home loan. When you take out the new loan, you’ll borrow a larger amount than what you currently owe on your house. This means you will pay off your existing loan and the leftover amount goes to you. That cash is up to you to use in whatever manner you choose, whether it be towards home improvements, college costs or other major expenses.
This type of loan is different than a traditional mortgage refinance because you’re not getting a new loan for the same amount you already owe. You’re actually getting a larger loan which replaces your old loan with a new set of terms.
Another reason for doing a cash-out refinance would be to lock in a lower interest rate. However, with interest rates seemingly on the rise, the window for locking in lower rates might be closing.
How Much You Can Get with a Cash-Out Refinance
As with most home equity loans, you’ll need to have a certain amount of home equity. Lenders usually limit homeowners to an 80% loan to value ratio. In other words, all loans on the property cannot exceed 80% of the appraised value of the home. For example, if your home’s value is $500,000 and you still owe $300,000 on your first mortgage, you have $200,000 of home equity. But you cannot borrow 100% of the value of your home. You’ll need to maintain 20% of home equity in most cases, which is equal to $100,000. That means you can borrow up to $100,000 on a cash-out refinance. If you were to borrow the full $100,000, your new loan would be for $400,000.
See a more complete example below:
Before cash-out refinance:
Appraised home value = $500,000
Existing mortgage balance = $300,000
Existing home equity = $200,000
After cash-out refinance:
Appraised home value = $500,000
New mortgage balance = $400,000
Updated home equity amount = $100,000
Cash in your pocket = $100,000
When It’s a Good Idea to Get a Cash-Out Refinance
A cash-out refinance is not right for everyone. In some cases, it may be able to help save you money if interest rates are lower. However, there are other alternatives like a home equity loan or a home equity line of credit, which also allow you to unlock the equity in your home.
Doing a cash-out refinance may make sense if you want to lock in a lower interest rate on your existing mortgage balance while also taking out some cash from your home equity.
Paying off other high-interest debt with a cash-out refinance can also be a good idea. For example, if you have credit card debt it might make sense to pay it off this way. Just keep in mind that you’d be converting unsecured debt to a loan that has your home as collateral. The consequences for not paying a mortgage are usually more drastic than not paying a credit card – you could actually lose your home.
When to Steer Clear of a Cash-Out Refinance
A cash-out refinance may help you save money on interest, but you may end up paying more due to closing costs, which are usually about 3% to 6% of your loan amount. These fees and expenses can cost you up to several thousand dollars depending on your loan amount. For example, if you’re taking out a loan for $175,000, you could be paying up to $10,000. You’ll need to do some careful calculations to see if it’s worth the cost.
If you don’t absolutely need the money for a specific reason, it might be better to leave your home equity alone. This could allow you to be debt-free one day when your home is entirely paid off.
As always with a mortgage, the biggest risk is that you’re using your home as collateral. You should be very confident you can make the payment on the loan every month to ensure that you will never default or get foreclosed on.
Alternatives to Cash-Out Refinancing
There are many options out there if you’re looking to tap into your home equity. Here are a few alternatives you can consider before doing a cash-out refinance:
HELOC: A home equity line of credit is just that, a line of credit against your home equity. It usually comes with a variable rate, meaning that your rate (and your monthly payment) can increase over time. These types of loans work kind of like credit cards, where you’re pre-approved up to a certain amount and can borrow up to that limit during the draw period.
Home Equity Loan: With this loan, you get a lump sum amount upfront and then pay it back over an agreed term. This type of loan usually has a fixed-rate, meaning your monthly payments stay the same for the duration of your loan.
Home Ownership Investment: Unlike a loan, a home ownership investment does not come with monthly payments. Instead, the company invests alongside you in your home, sharing the potential appreciation in the home’s value. With the Unison HomeOwner program from Unison, you can unlock equity in your home and use it for any purpose you choose. Whenever you sell the home – up to 30 years later – Unison receives a portion of the home’s increase in value, if any. In some cases, the company will also share in the loss if your home has declined in value. You can learn more about the program here.
Personal Loan: People often use a personal loan for major purchases, home improvement, or debt consolidation. Instead of a 15-30 year term, a personal loan term is usually much shorter, typically around 5 years. However, interest rates may be higher compared to a mortgage or home equity loan, depending on your credit score.
The Bottom Line
Cash-out refinancing is one option for unlocking the equity in your home. If you can find a low interest rate and afford to pay the closing costs, it might be a good idea. Either way, it is always smart to look into the alternatives mentioned above. Talking to a reputable and qualified professional can help you make an informed decision.
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