Do you need a large amount of cash to pay down some debts? Maybe renovate your home, or finance your child’s education? How about you go for a cash-out refinance? If your home value has increased and interest rates are hovering very low, tapping your home equity can be a great option. With a cash-out refinance, you can typically take out almost 80% of your home equity. The idea sure sounds good, but before you dive into it, let’s discuss how it actually works.
Below you will find everything you need to know about using some of your home equity in a refinance.
What Is a Cash Out Refinance?
A cash-out refinance is a loan option that replaces your old mortgage with a new one. This loan is higher than your previously existing loan balance but, helps borrowers get money out their home mortgage to use for their financial goals.
In the real estate world, refinancing, in general, is about replacing an old mortgage with a new one. This new mortgage introduces the borrower to more fortunate terms. By refinancing your mortgage, you may be able to decrease your monthly interest rate, negotiate lower monthly mortgage payments, modify periodic terms, and yes, potentially take out money.
To use this type of refinance, you must have a considerable amount of equity built-up on your home.
- In cash-out refinance, a replaced mortgage is more than your previous outstanding mortgage balance. You receive the difference disbursed to you.
- Usually, a borrower pays more points or a higher interest rate on a cash-out refinance mortgage.
- A lender decides how much cash you will receive with your refinance. This is based on your current credit profile, bank standards, and your home’s loan-to-value ratio.
How A Cash-Out Refinance Works?
Here is an example of what a typical cash-out refinance might look like.
Suppose you took out a mortgage of $200,000 to buy a property worth $300,000, and after many years, you still owe your lender $100,000. If we assume that property value is still $300,000, you have an equity build-up of at least $200,000. Having equity can make you eligible for a cash-out refinance.
Typically, lenders are willing to pay around 75% of a home’s value. For a $300,000 property, this amount would be around $225,000. Now, if you have a remaining principal of $100,000, you have a good chance of receiving $125,000 in cash, which is the difference. The whole process generally looks like this
- 75% of a home’s value: $225,000
- Remaining principle: $100,000
- Cash-out: $125,000 (minus the closing cost)
If you decide to take out only $50,000 of cash, you would refinance with a $150,000 mortgage loan that would come with new terms and lower rates. The replaced mortgage will consist of the $100,000 remaining loan principal and $50,000 that you cashed out.
When Is It Best To Cash Out From Your Equity?
A cash-out refinance is a good option to maybe lower your interest rate on a new mortgage. Also, if you want to use some of the equity in your home. But, seeking a cash out refinance to fund a new car or a vacation might not be a good idea. This is because you will have little or no return on your a car. You really shouldn’t use cash to pay for liabilities. You should buy assets that can create consistent cash flow and with that cash flow maybe buy the liability.
That being said, you can use the cash from the refinance for any of your financial goals. Most homeowners cash out their equity for the following reasons:
Investment purposes: A cash-out refinance provides homeowners with capital to help them purchase an investment property. You can also fund a retirement vehicle assuming the return is higher than your interest rate on the loan.
Home improvement: Use the money from a cash-out refinance for a kitchen or bathroom remodel. Also, updating furniture is a sound option and can benefit you in the long run.
Consolidate debt: refinance rates are comparatively lower than other forms of debt like credit cards. The proceeds can help homeowners pay these debts off, and pay the mortgage back in one, lower-cost, monthly installment.
Child’s education fund: Education is expensive. Taking money from your home equity is a wise option if you get the interest rate lower than your child’s student loan.
What Are The Benefits Of A Cash-Out Refinance?
This loan has many advantages over other types of loan models if you are anticipating a large sum of cash. Here are some common reasons you should opt for a cash-out refinance:
- With cash-out refinancing, you will typically get a higher rate on your mortgage. This is the main reason why people prefer traditional refinancing.
- If your home improvement project increases your home value, tapping into your home equity can actually deduct the mortgage interest from the taxes. You would want to talk to your tax advisor on this. Also, the cash-out refinancing option can be much less expensive than personal loans or credit cards.
- Paying your debts off with a cash-out refinance makes a lot of sense. However, make sure you do the math first. This move is only beneficial when you can reduce the interest rate on your primary loan and make good use of the cash you take out.
- Mortgage debt can be repaid over a typically longer period as compared to other types of debt. In most cases, this period goes up to 30 years, so it can make paying a large amount of debt a little less troublesome.
Is There Any Fee For a Cash-Out Refinance?
While doing a cash-out refinance, expect to pay 3-4% of the new mortgage amount for the closing costs. Your closing cost would consist of your lender origination fee. To get the most competitive rate and terms, search the market and shop around for multiple lenders.
My Final Take
Before diving into the process, make sure that a cash-out refinance is the right option for your financial goals. Remember that you are actually using your house as collateral, which means you may lose it if you fail to pay the new mortgage. Tapping your home equity is a decision that you should make wisely. It is a strategic way to boost your financial profile.
Whenever you decided to take money out of your equity in your home, there should be a really good plan for the funds set forth. Many people take a cash out refinance to pay off credit card debt and that in and of itself is not a bad idea. You want to keep in mind that should we face another mortgage crisis like we did in 2008 – 2010, the value of your home could fall. Furthermore, if your home holds less value than your loan, you are upside down in value versus cost. Plus, you still have to pay the higher mortgage. For this reason, I do not consider your home an asset as it by itself does not produce cash flow.
Uses of the New Loan
If you are using the funds from a refinance to fund an investment or increase cash flow in some manner, then that is a positive way to use the funds. Remember, an asset is anything that puts money in your pocket. Debt is not a bad thing, but it can be used for the wrong reasons. There are many very successful people who use debt as a tool to become more successful.
The last point I want to bring up in this final take section is another use for the funds from your new loan is to fund a personal business. A personal business, even as a side hustle to start can offer an additional stream of income. The wealthy have at least 5 streams of income. If you are relying only on a paycheck as your only source of income, then that is very scary place to be. Take the chance to learn something new and explore other side business opportunities.
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