If you’ve owned your home for a while, you’ve probably earned some equity in it. With today’s low rates, you may be eligible to tap into that equity, using the money you’ve earned in the home, putting it to good use with a cash-out refinance.
Check out our complete guide on cash-out refinancing below.
What is a Cash-Out Refinance?
A cash-out refinance is a loan with a loan amount higher than your current mortgage. It provides the opportunity to tap into your home’s equity, using the difference between your loan payoff and the new loan amount as you wish.
Like a traditional mortgage, the mortgage cash-out loan uses your home as collateral. To be eligible, your home must be worth more, and/or you must have paid your loan balance down, so you have equity in the home.
Equity is the difference between your home’s current value and your outstanding loan balance. You earn equity each month as you pay your mortgage down and as your home value increases.
How Does Cash-Out Refinancing Work?
When you use the cash-out refinance option, you refinance your current first mortgage with a new mortgage. The new mortgage has a higher loan balance, new term, and a new interest rate. You may even get a cash-out loan from a new lender.
The new loan pays off your existing mortgage and takes its place as the first lien position. The difference between the amount used to pay off your first mortgage (and any fees you wrap into it), is yours, which you receive as cash.
How do you Qualify for Cash-Out Refinancing?
Every lender has its own set of requirements, but in general, here’s what you’ll need.
An Average Credit Score of 620+
Lenders take a larger risk when giving you a mortgage cash-out loan. They lend you more money than you borrowed, assuming you can pay the loan back. A higher credit score shows lenders you are responsible for your finances.
Each loan program has a different credit score requirement, but on average you will need at least a 620, but a higher credit score earns you better terms and lower interest rates.
A Low Debt-to-Income Ratio
Your debt-to-income ratio compares your total monthly debts to your gross monthly income (income before taxes). The lower your DTI, the less risk of default you pose. On average, lenders prefer a DTI of less than 50% when considering cash-out refinancing.
If you have compensating factors, such as great credit or you borrow less than 80% of the home’s value, you may get away with a slightly higher DTI.
There are also multiple ways to calculate the I (income) in DTI depending on if you are self-employed or not. This includes using bank statements, business income, and even asset depletion from investment accounts.
This goes without saying. You can’t borrow from your home’s equity if you don’t have any equity in it. Overall, you can borrow up to 80% of the home’s equity. This includes your current first mortgage.
For example, with a conventional mortgage, if your home is worth $200,000, you can borrow up to $160,000. If your first mortgage has a balance of $100,000, that leaves you with $60,000 in equity that you can withdraw.
However, there are newer products such as Non-QM and Non-Conventional products that you may be able to borrower up to 100% of your home’s equity.
How Soon can you Refinance and get Cash Out?
Some loans may require you to wait at least 6 months before you take equity out of your home. This depends on many factors such as FHA, VA, Conventional, USDA, or Non-Conventional loan. We always recommend speaking with a mortgage professional as oftentimes guidelines and overlays on cash-out refinancing are changing.
What can you use a Cash-Out Refinance For?
- Home renovations – Using your home’s equity to fix up your home can be the best use of your home’s equity. You reinvest in your home, possibly increasing its value, earning your money back that you borrowed from the home.
- Debt consolidation – If you have high-interest credit card debt, you may feel like there’s no light at the end of the tunnel. Consolidating your debt with a low-interest mortgage may lower your monthly payments, and consolidate the number of bills you have each month.
- Invest the money – Some homeowners want the equity out of their home to invest the money elsewhere. If you know of ‘other investments that may earn money faster than your home appreciates, you can withdraw the funds to invest it.
- Emergency fund – If you don’t have liquid assets on hand, liquidating your home’s equity may give you peace of mind should a financial emergency occur.
Who Benefits from a Cash-out Refinance?
Homeowners with equity in their home can benefit from a cash-out refinance if:
- A lower interest rate is available than their current interest rate.
- There is enough equity in the home to borrow the funds needed.
- The funds will be used to make home renovations that may improve the property’s value.
- Using the equity will make managing monthly debts easier by consolidating high-interest consumer debt.
- Using the equity to start a business or for an investment.
Like any mortgage program, there are pros and cons to the cash-out refinance. Knowing the ‘good and bad’ will help you decide.
Pros of the Cash-Out Refinance
- With a cash-out refinance you may get a lower interest rate. Today’s rates are lower than we’ve seen in decades. Even if you take out a larger loan amount, you may lower your current interest rate and save money overall.
- You may be able to consolidate debt with a cash-out refinance. No one likes paying 19 – 24% on credit card debt. If you can consolidate your debt into your home equity, you can save money on interest charges.
- If you use the funds to improve your home, you may have tax benefits. If you itemize your deductions, mortgage interest can be something you write off.
- You can get money for any use with a cash-out refi. Whether you need money for an emergency fund, another investment, to buy another property, or to pay for college, you can use the funds as needed.
Cons of the Cash-Out Refinance
- Your interest rate may increase with a cash-out refi. Depending on your credit score and other qualifying factors, you may get a rate higher than you have now, which means a much higher mortgage payment.
- Wrapping your consumer debt into your home mortgage drags out the repayment for 15 to 30 years, which may mean more money paid on the debt over the long haul.
- You put your home at risk. If you default on your mortgage because it’s a higher loan amount and payment, you may lose your home.
- You may be tempted to use money that isn’t necessary. Using your home as a piggybank can lead to needless spending and other financial issues.
Alternatives to the Cash-Out Refinance
A mortgage cash-out loan isn’t the only option when you need money. Here are the alternatives:
• Home equity line of credit – A HELOC taps into your home equity, but as a second mortgage, leaving the first mortgage alone. A HELOC works like a credit card – you get a credit line that you can use or leave untouched. You only make interest payments on the funds you withdraw, and you can use the line for up to 10 years.
• Home equity loan – A home equity loan provides your home’s equity in one lump sum rather than a line of credit. You make principal and interest payments right away, which makes it easier to budget.
• Personal loan – A personal loan is usually unsecured, unlike the HELOC or home equity loan. Because it’s unsecured (no collateral), you’ll pay higher interest rates and may face tougher requirements.
• Credit card – If you have credit cards with a high credit limit, they are an option but know the APRs. If you have a 0% APR for a certain amount of time and you know you can pay the balance off by then, it could be a good option. Otherwise, credit cards can get expensive and hard to pay off.
Is a Cash-Out Refinance Worth It?
A cash-out refinance can be the answer many homeowners need. If you’re in over your head in debt, want to make home improvements, or just want money on hand, now is a great time to tap into your home’s equity.
Like any mortgage or real estate transaction, make sure you know the fees, rate, and loan terms before you proceed with a cash-out refinance. Take the shortest term you can and make sure you’re getting the interest rate you deserve based on your credit score and other qualifying factors. Using your home equity for big financial decisions can be a great way to use the largest investment in your life – your home.