Owning a home comes with many advantages. Among them is building home equity as your property value rises and you pay down your mortgage balance. If you’re sitting on a lot of home equity, a cash-out refinance may be your opportunity to put it to good use.
A cash-out refinance gives you access to the equity in your home while still maintaining a mortgage. This allows you to use the cash for home improvements, debt consolidation, or even a nice vacation.
Though a cash-out refinance can be an efficient way to access funds, It’s important to consider the pros and cons when determining if it’s right for you.
- What is a cash-out refinance?
- Pros of this form of refinancing
- Cons of a cash-out refinance
- Should I get a cash-out refinance?
- Frequently asked questions
What is a cash-out refinance?
A cash-out refinance is a type of mortgage refinance that allows you to use the equity you’ve built in your home. When you refinance, your loan is replaced with a new mortgage worth more than what you currently owe. You’ll use the new loan to pay off your mortgage, and use any remaining cash as you see fit.
While there are many reasons homeowners may want to consider a cash-out refinance (such as a refinance on an investment property), it’s not always the smartest move. For example, even if you’re able to get a lower interest rate through refinancing, you’re still borrowing a larger loan amount. This means you may have higher monthly payments or the length of your loan might be extended. A longer repayment term means you’re paying more in interest over time.
On the other hand, there are several benefits of using a cash-out refinance. You might be able to improve your credit score by using the cash to repay debt (thus, lowering your credit utilization ratio), or you can increase the value of your property by making home improvements.
Cash-out refinance pros
Cash-out refinances are an increasingly popular way to put the equity you’ve built in your home to use. Here are some of the biggest pros of a cash-out refinance:
Lower interest rates
One of the biggest benefits of a cash-out refinance is the potential to secure a lower interest rate on your mortgage. If your credit score has increased or interest rates have lowered since taking out your original mortgage, you might be able to qualify for a new loan at a lower rate. This can potentially reduce your monthly payments and long-term loan costs.
Open the door to tax benefits
The interest paid on a cash-out refinance may be tax-deductible, similar to how your original mortgage’s interest was deductible. The IRS doesn’t consider the lump sum of cash as income, but rather as just another mortgage.
That said, your ability to deduct your interest payments depends largely on how you use the funds you’re getting from your refinance. Generally, you can only benefit from tax deductions if you use your cash-out refinance to make improvements that increase your property’s value.
Debt consolidation
If you’re burdened by high-interest credit card debt or costly medical bills, a cash-out refinance may be able to provide the funds needed to pay down your balances at a lower rate. Because you can use the money from a cash-out refinance however you need, you can put it toward paying off as many debts as possible.
Additionally, by paying down your balances, you may be able to improve your credit score by improving your debt-to-income (DTI) ratio and lowering your credit utilization ratio.
Cash-out refinance cons
A cash-out refinance has a variety of worthwhile purposes, but it’s also important to be aware of the drawbacks. Here are a few to consider:
Potentially higher interest costs
The primary con associated with cash-out refinances is that you risk getting stuck with a higher interest rate than you’re currently paying.
You can qualify for better rates if you’ve improved your credit score and the market is in your favor as a buyer’s market. But if you have poor or fair credit, you likely won’t see an interest deduction at all and could actually face a higher rate.
Closing costs
Closing costs associated with a cash-out refinance can be considerable. You’ll pay closing costs similar to when you originally bought your property. These can include:
- Attorney costs
- Appraisal costs
- Tax service fees
- Origination and underwriting fees
- Credit report fees
These costs add up to about 2% to 5% of your loan total, according to Spirit Financial Credit Union.
Longer loan term
When you refinance your home through a cash-out refinance, you’re often extending the loan repayment term due to taking on a more expensive mortgage. While this can help keep your monthly payments low, it can cause some problems, too.
“This lower payment is frequently caused by extending the term of the new home loan. While the monthly payment can be lower, if a homeowner does not have a proper plan in place, a cash-out can cost more than it is worth,” said Raul Hernandez, a licensed Colorado mortgage officer.
Because you’re paying off your mortgage for a longer amount of time, you’ll also continue to pay interest over the life of your loan. A longer mortgage can result in greater interest charges over time.
Foreclosure
Because a cash-out refinance is secured with your property as collateral, you’ll risk losing your home to foreclosure if you can’t keep up with payments or default on the loan. To avoid losing your home, be sure to only borrow what you can afford to repay and pick a loan term that allows you to fit your monthly payments easily into your budget.
Is a cash-out refinance right for me?
When deciding if a cash-out refinance is right for you, consider the following:
- Do I have enough equity in my home to justify a cash-out refinance? If you don’t have enough equity in your home or if the amount of money you’d get after paying off your existing mortgage is too small, a cash-out refinance likely isn’t worth pursuing.
- Can my current financial situation handle the costs associated with refinancing? This product comes with closing costs and other potential fees, depending on the cash-out refinance lender. While you may get the cash you need, it’s important to consider if you can handle these additional expenses.
- How do I plan to use the funds? A cash-out refinance might be a good idea if you put the money toward paying off debt or making home improvements or can get a lower interest rate than you’re currently paying. On the other hand, you might want to consider other options if you want to pay off your mortgage sooner, if cash-out refi rates are higher than your current mortgage rate, or if you’re faced with significant closing costs.
- Is now a good time to pull equity out of my home? Taking equity out of your home can have both financial and personal ramifications. Take into account the housing market conditions and your own financial situation. Consider your personal timeline and goals when evaluating a cash-out refinance. Finally, make sure that you’re comfortable with the idea of taking on additional debt to use the proceeds from the cash-out refinance.
Frequently asked questions
Do I still need a good credit score to qualify for a cash-out refi?
Yes, you typically still need a good credit score to qualify for a cash-out refi. The exact score you need largely depends on the loan you’re refinancing. For example, FHA loan refinances require at least a 580 credit score to qualify.
The higher your credit score, the lower the interest rate you’ll likely get for your refinance. If your credit score has fallen since you got your original mortgage, a cash-out refi likely isn’t a good option, as you could get stuck with an even higher interest rate.
How long does a cash-out refinance take?
The cash-out refinance process typically ranges from 45 to 60 days. If you meet eligibility requirements and can quickly provide the necessary paperwork (such as pay stubs and recent W-2s), you may be able to speed up the process. Otherwise, if there’s more documentation required, the timeline may be extended.
Will I still pay closing costs?
Yes, you may still have to pay closing costs, depending on the terms of the refinance. In a cash-out refinance, you’re still obligated to pay any closing costs required to transfer the title to the new lender. Be sure to speak with your lender about all closing costs prior to signing off on your new loan.
Will I need a home appraisal?
Yes, in most cases, you will need a home appraisal for a cash-out refinance. A professional appraisal provides an estimate of your property’s value. That value determines the maximum loan amount you can receive. Appraisals can also identify any property defects or necessary repairs, which can affect your loan amount as well.
How is a cash-out refinance different from a home equity loan?
A cash-out refinance pays off your existing mortgage and replaces it with a new loan, while a home equity loan is a second mortgage secured with the equity in your home as collateral. (You might also consider a home equity line of credit.)
They’re both installment loans where you’ll receive a lump sum of cash and repay it in equal installments over a set period of time. With both forms of financing, you risk foreclosure if you default on payments because your house secures the loan.
With a cash-out refinance, you refinance your mortgage for a loan larger than your current balance and receive the difference as a lump sum of cash. With a home equity loan, you’ll borrow against the equity in your home without refinancing. You can use the funds from both a cash-out refi and a home equity loan for a variety of expenses, from home improvements to debt consolidation.