What Is a Cash-Out Refinance?
A cash-out refinance is a mortgage-refinancing option in which an old mortgage is replaced by a new one with a larger amount than owed on the previously existing loan, helping borrowers use their home mortgage to get some cash.
In the real estate world, refinancing in general is a popular process for replacing an existing mortgage with a new one that typically extends terms to the borrower that are more favorable. By refinancing a mortgage, you may be able to decrease your monthly mortgage payments, negotiate a lower interest rate, renegotiate the periodic loan terms, remove or add borrowers from the loan obligation, and potentially access cash.
- In a cash-out refinance, a new mortgage is for more than your previous mortgage balance, and the difference is paid to you in cash.
- You usually pay a higher interest rate or more points on a cash-out refinance mortgage compared to a rate-and-term refinance, in which a mortgage amount stays the same.
- A lender will determine how much cash you can receive with a cash-out refinancing, based on bank standards, your property’s loan-to-value (LTV) ratio, and your credit profile.
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Pros and Cons of a Cash-Out Refinance
Refinancing your mortgage can be a great way to reduce one of your largest monthly expenses. Savvy investors watching the credit market over time will typically jump at the chance to refinance when lending rates are falling toward new lows. Mortgage contracts may have terms specifying when and if a mortgage borrower can refinance their mortgage loan. There can be a variety of different types of options for refinancing.
However, in general, most will come with several added costs and fees that make the timing of a mortgage loan refinancing just as important as the decision to refinance. The Consumer Financial Protection Bureau (CFPB) has a number of excellent guides to help determine if a refinance is a good choice for you.
In addition to checking rates and fees to make sure that refinancing is a good option, consider the reasons for needing the cash. A cash-out refinance is one of the cheapest ways to get cash in terms of interest paid, but it comes with either the very high risk of losing your home if you can’t keep up with increased mortgage payments or the value of your home going down and you ending up underwater on your mortgage. If you need the cash to pay off consumer debt, take the steps you need to get your spending under control so you don’t get trapped in an endless cycle of debt reloading.
The cash-out refinance can be one of the borrower’s best options. It gives the borrower all of the benefits they are looking for from a standard refinancing, including a lower rate and potentially other beneficial modifications. With the cash-out refinance, borrowers also get cash paid out to them that can be used to pay down other high-rate debt or possibly fund a large purchase. This can be particularly beneficial when rates are low, or in times of crisis—such as in 2020–21, in the wake of global lockdowns and quarantines, when lower payments and some extra cash can be very helpful.
How Does a Cash-Out Refinance Work?
Here’s how a cash-out refinance works. The borrower finds a lender willing to work with them. The lender assesses the previous loan terms, the balance needed to pay off the previous loan, and the borrower’s credit profile. The lender makes an offer based on an underwriting analysis. The borrower gets a new loan that pays off their previous one and locks them into a new monthly installment plan for the future.
With a standard refinance, the borrower would never see any cash in hand, just a decrease to their monthly payments. A cash-out refinance can possibly go as high as approximately 125% of loan to value. This means that the refinance pays off what they owe and then the borrower may be eligible for up to 125% of their home’s value. The amount above and beyond the mortgage payoff is issued in cash just like a personal loan.
Individuals with specialty mortgages like U.S. Department of Veterans Affairs (VA) loans or Federal Housing Administration (FHA) loans qualify for specialty refinance options. VA loans can often be refinanced through more favorable terms with lower fees and rates than non-VA loans. FHA loans qualify for streamlined refinancing, but the limit of cash-out on a streamlined FHA loan refinancing is $500.
Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
Rate-and-Term vs. Cash-Out Refinance
As mentioned above, borrowers have a multitude of options when it comes to refinancing. The most basic mortgage loan refinance is the rate-and-term refinance, also called no cash-out refinancing. With this type, you are attempting to attain a lower interest rate or adjust the term of your loan, but nothing else changes on your mortgage.
For example, if your property was purchased years ago when rates were higher, then you might find it advantageous to refinance to take advantage of lower interest rates that now exist. In addition, variables may have changed in your life, allowing you to handle a 15-year mortgage (saving massively on interest payments), even though it means giving up the lower monthly payments of your 30-year mortgage. With a rate-and-term refinance, you could lower your rate, adjust to a 15-year payout, or both. Nothing else changes, just the rate and term.
Cash-out refinancing has a different goal. It allows you to use your home as collateral for a new loan as well as some cash, creating a new mortgage for a larger amount than what is currently owed. You receive the difference between the two loans in tax-free cash (the government does not count the money as income—it is more like a mortgage-personal loan hybrid). This is possible because you only owe the lending institution what is left on the original mortgage amount. Any extraneous loan amount from the refinanced, cash-out mortgage is paid to you in cash at closing, which is generally 45 to 60 days from when you apply.
Compared to rate-and-term, cash-out loans usually come with higher interest rates and other costs, such as points. Cash-out loans are more complex than a rate-and-term and usually have higher underwriting standards. A high credit score and lower relative loan-to-value (LTV) ratio can mitigate some concerns and help you get a more favorable deal.
Example of a Cash-Out Refinance
Say you took out a $200,000 mortgage to buy a property worth $300,000, and, after many years, you still owe $100,000. Assuming that the property value has not dropped below $300,000, you have also built up at least $200,000 in home equity. If rates have fallen and you are looking to refinance, you could potentially get approved for 100% or more of your home’s value, depending on the underwriting.
Many people wouldn’t necessarily want to take on the future burden of another $200,000 loan, but having equity can help the amount you can receive as cash. Typically, banks are willing to lend out around 75% of a home’s value. For a $300,000 home, this would be around $225,000. You need $100,000 to pay off the remaining principal. This leaves you with a good chance for getting $125,000 in cash.
If you decide to only get cash of $50,000, you would refinance with a $150,000 mortgage loan that has a lower rate and new terms. The new mortgage would consist of the $100,000 remaining balance from the original loan plus the desired $50,000 that could be taken out in cash.
In other words, you can assume a new $150,000 mortgage, get $50,000 in cash, and begin a new monthly installment payment schedule for the full amount. That’s the advantage of collateralized loans. The disadvantage is that the new lien on your home applies to both the $100,000 and the $50,000, since it is all combined together in one loan.
Cash-Out Refinance vs. Home Equity Loan
What’s the difference between a cash-out refinance and a home equity loan? Well, with a cash-out refinance, you pay off your current mortgage and enter into a new one. With a home equity loan, you are taking out a second mortgage in addition to your original one, meaning that you now have two liens on your property, which translates to having two separate creditors, each with a possible claim on your home.
Closing costs on a home equity loan are generally less than those for a cash-out refinance. If you need a substantial sum for a specific purpose, home equity credit can be advantageous. However, if you can get a lower interest rate with a cash-out refinance—and if you plan to stay in your home for the long term—then the refinance probably makes more sense. In both cases, make sure of your ability to repay because, otherwise, you could end up losing your home.
The Bottom Line
Getting cash by using your home as collateral through a cash-out refinance, home equity loan, or home equity line of credit (HELOC) can be an easy way to get cash for emergencies, expenses, and wants. These options typically come with lower interest rates than unsecured debt like credit cards or personal loans. However, unlike a credit card or personal loan, you can lose your home if you can’t pay your mortgage, home equity loan, or HELOC. Carefully consider if what you need the cash for is worth the risk of losing your home if you can’t keep up with payments in the future.