Each time you make a mortgage payment, you’re investing in your home. As you pay down your loan, you create equity.
In some situations, home equity can be used as a cash reserve that you can tap into for certain life expenses. This could include paying for home renovations or paying off debts that have higher interest rates.
Let’s explore how cash-out refinances work and when they might provide the most financial benefits.
What is a cash-out refinance?
With a cash-out refinance, you replace your current mortgage with a new loan that’s higher than what you owe on your home. You receive money from the difference between the mortgage balance and your home’s value.
Because you get a new loan, you will also likely have new terms for the loan, such as a different interest rate or length of time to pay off the loan.
Understanding home equity
Anyone who has a financial claim to a property has an “interest” in it, so your home equity is the interest you have in your home. As you pay down a mortgage, your lender’s interest in the property decreases, and yours increases, building your equity. It also rises if the value of your property increases over time.
The more equity you have in your home, the more options you have to use that equity to finance other life expenses. With a cash-out refinance, the amount of cash you can access is limited to 80-90% of your home’s equity, depending on your finances and the type of loan.
Depending on your finances and the terms of your current mortgage, there is a possibility you’re eligible for an FHA or Conventional refinance loan. If you’re active-duty or a veteran, view the unique VA*** refinance options here.
***VA loans subject to individual VA Entitlement amounts and eligibility, qualifying factors such as income and credit guidelines, and property limits. Fairway is not affiliated with any government agencies. These materials are not from VA, HUD or FHA, and were not approved by VA, HUD or FHA, or any other government agency.
When a cash-out refinance makes sense (and when it doesn’t)
A cash-out refinance can be used for several situations, such as renovating a home, paying off credit card debt, and paying college tuition.
Deciding whether it’s a good idea for your situation comes down to whether you’ll be better off financially or if the costs will outweigh the benefits.
When it’s a good idea to refinance
- If interest rates are lower than when you closed your original mortgage, a new refinance loan could give you a better interest rate, which could lower your monthly payments and the cost of your mortgage over its lifetime.
- You can use the cash to consolidate and pay off high-interest debt. As mortgage rates can be lower than other types of loans, this can be a more affordable option to borrow money to pay down debt.
- One of the most common uses for a cash-out refinance is to use the cash for home renovations. With this, you’ll invest the money back into your home, which can help to raise its value.
- Invest the money in education or business. If you use the money to invest in something that will take you on a path to earning more income, it can be smart to do a cash-out refinance now.
When it’s not such a good idea
- With a new loan comes new closing costs. Make sure that the costs don’t eat up too much of the cash you expect to receive. For example, if your closing costs are $8,000 and you want $10,000 in cash, a refinance isn’t the best option.
- As a cash-out refinance is a new loan, if you borrow more than 80% of your home’s value, you’ll need to pay private mortgage insurance, which adds to the overall costs of your mortgage and creates a higher monthly payment.
- A new mortgage could have a longer term. Stretching out the debt over several years means large amounts of added interest costs.
- Increasing your loan and decreasing your equity puts you at higher risk of losing your home if you can’t make the payments on your new mortgage. Your home is the collateral, so if you fail to make payments, you may lose your home. This makes a cash-out refinance less ideal if you’re using it to pay down credit card debt, which can be riskier if you aren’t financially stable.
Getting the timing right
If you only plan to live in your home for a few more years, a cash-out refinance might not be worth the costs.
Closing costs can be 2-5% of the loan amount. If your cash-out refinance loan is for $150,000, the closing costs could be between $3,000 and $7,500. If you don’t plan on living there long enough to earn back the expenses of a new mortgage, the costs can outweigh the benefits.
To avoid paying closing costs up front, you might be eligible for a no-closing-costs loan option where the costs are rolled into the loan amount, to be paid over the lifetime of the loan. This could often raise your interest rate though.
It’s important to check with your loan officer to understand how the terms of a refinance will affect your finances. For example, you might have to pay a prepayment penalty if you move out soon after refinancing. Some loan programs require you to have lived in the home for at least one year before you can refinance.
Is a cash-out refinance right for you?
To learn more about whether a cash-out refinance is right for you, speak with a loan officer to discuss your needs and the options available to you.
Reach out to us to get started and we can help you get the most out of your home.