A cash-out refinance can help you get out of debt and/or give you a lower interest rate. It’s not always the right choice for everyone, though. Here we’ll discuss the benefits of this mortgage program and who it suits the most.
Cash-Out Refinance Defined
A cash-out refinance is a refinance of your existing mortgage, but the loan amount exceeds your current outstanding balance. Unlike a rate/term refinance, you can take a larger loan amount than you currently have. The amount that is above and beyond your current outstanding mortgage comes to you in cash. You are then free to use it as you see fit.
Qualifying for a Cash-Out Refinance
In order to qualify for a cash-out refinance, you need one thing – home equity. Most loan programs allow an LTV up to 85% for this type of program. There are some that don’t allow more than 80%, though. Here’s how it works:
Let’s say you have a current 1st mortgage with a $100,000 outstanding balance. Your home is worth $200,000. You have $100,000 in home equity. A lender that allows up to 85% LTV for a cash-out refi will allow a new loan amount up to $170,000. This leaves you with $70,000 in cash.
Aside from the LTV, lenders will generally require a higher than average credit score and low debt ratio. Giving you cash out of your home equity is risky for a lender. They are letting you take on a higher loan amount and higher payment. The risk for default is higher for them than it was for your original loan. It’s not unusual to see lenders that require at least a 700 credit score before giving a cash-out refi. Yet others will allow scores as low as 660. It just depends on the lender’s requirements.
The Benefits of a Cash-Out Refinance
Now that you know how to qualify for this refinance program, it’s time to learn the benefits.
- Debt consolidation – If you have multiple debts that cost you a lot of interest, consolidating them into your mortgage may help. First mortgages tend to have much lower interest rates than credit cards, personal loans, and even home equity loans. With the cash-out refi, you can save money on interest and have only one payment to make.
- Tax savings – You may be able to write off the interest you pay on your new mortgage. This depends on your individual situation and would be best addressed with your tax advisor. However, you would not be able to write off interest on any other loan including credit cards or personal loans.
- Increase your credit score – If you consolidate your debt, you free up your utilization rate. You have less debt outstanding compared to what you may have available. This will help increase your credit score quickly. If you also make your mortgage payments on time, it can help improve your score as well.
- Pay for home improvements – One of the best ways to use your home equity is to invest right back into your home. If you want to remodel the kitchen or bathroom, you can use the funds from your home. You’ll see a return on your investment by increasing the value of your home. Many people think of this as the best way to use their home equity.
If you need cash, a cash-out refinance isn’t your only option. For example, if you have a great interest rate on your first mortgage right now, you might not want to lose it. Generally, cash-out refi rates are slightly higher than rate/term rates. If you already have a low rate, you may lose it by refinancing your debt. You do have the option to leave your first mortgage alone and still tap into your home equity. You can do this with a home equity loan or home equity line of credit.
Both loans are second mortgages. You take out just what you need and leave the first mortgage untouched. The home equity loan is a one-time disbursement. You receive the money at the closing and make principal and interest payments over the life of the loan.
A home equity line of credit works more like a credit card. The lender puts your money into a checking account. You can then take the money as you need using either a debit card or by writing a check. You only owe interest on the money you use each month. This happens for the first ten years. After the draw period ends, you then make principal and interest payments for the remainder of the term, which is usually 20 years. If you choose to pay the funds back that you used during the draw period, you can use them again and again until the draw period ends.
Look at all of your options when you are considering a cash-out refinance. For some it’s the right choice. For others, a second lien or even a personal loan might be a better option. Look at the big picture. Consider the benefits and the total cost of the loan over the entire 15 – 30 years. Talking to several lenders can help you see your available options as well.