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Cash-Out Refinance: What It Is And How It Works

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Published on May 17, 2022
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Buying a home is a huge investment. In fact, it’s such a large investment that sometimes paying on your home loan can make it difficult to save for other financial milestones. But if you have equity in your home, you may be able to use it to fund home renovations, to consolidate debt or to put toward whatever your heart – and wallet – desires.

There are several routes you can consider to access your equity. One of those options is a cash-out refinance. But what is a cash-out refinance, how does it work and how do you know if it’s right for you? We’ve got you covered in this comprehensive guide.

What Is A Cash-Out Refinance?

A cash-out refinance is a type of mortgage refinance that allows homeowners to refinance their existing loan and turn the home equity they have into cash. This is done by replacing their existing mortgage with a new one with a higher loan amount than what they owe on their home.

Your home equity is the difference between your home’s value and what you owe on your mortgage. By borrowing more than what you owe, you’re able to access your equity to fund other projects, while also getting an opportunity to rework the terms of your original loan, potentially lowering your interest rates.

How Does A Cash-Out Refinance Work?

Unlike a second mortgage, which adds an additional monthly payment, a cash-out refinance replaces your original loan.

For example, let’s say your current home value is $230,000 and you have $150,000 left to pay on your mortgage. That would mean you have $80,000 in home equity. Maybe you want to dip into that equity to pay off credit card debt or maybe you need it to finance home repairs.

Whatever the reason, a cash-out refinance might be a good option. By refinancing your $150,000 mortgage to $165,000, you can take out the difference in a lump sum of cash.

The exact amount of equity you can access will depend on your home’s appraised value and your chosen lender. In general, lenders will not allow you to withdraw more than 80% of your home’s value.

What Are The Requirements Of A Cash-Out Refinance?

A cash-out refinance, or cash-out refi, typically has three requirements: a good credit score, an acceptable debt-to-income ratio and a decent amount of home equity. To help you understand if you meet these qualifications, let’s take a closer look at each.

Credit Score

To qualify for any mortgage refinance, you’ll usually need a credit score of at least 580. But for a cash-out refi, your credit score will usually need to be 620 or higher. However, there are exceptions to the rule.

If you're getting a VA loan, you can take cash out with a credit score as low as 580 as long as you leave 10% equity in your home. If your score is 620 or better, you can cash out all of your equity.

If you have your loan currently serviced by Rocket Mortgage®, you can take cash out using an FHA loan and a median score of 580 as long as you're using it to pay off debt at closing.

Debt-To-Income Ratio

An acceptable debt-to-income (DTI) ratio for a cash-out refi is no higher than 50% of your income. Your DTI ratio represents the percent of your gross monthly income used to pay debt payments.

Home Equity

Your home should have a sizable amount of equity built up in order to take full advantage of a cash-out refinance. Your lender won’t allow you to cash out all your equity because of the risk involved, so it’s a good rule of thumb to plan to keep 15% – 20% equity in your home after the refinance.  Inserted trip for chair one

How Can A Cash-Out Refinance Help You?

A cash-out refinance can be attractive for several reasons, but how might you use one to accomplish your financial goals? Here are just a few ways the value of your home could come in handy.

Home Improvement And Renovation Projects

One popular way to use a cash-out refinance is for home improvements. If your home needs major renovations or updates to boost your resale value, a cash-out refi may provide a convenient way to access the large sum of money you need. Upgrades like a new roof, solar panels or building an addition may be good uses of your home’s equity.

Debt Consolidation

Debt consolidation can be another motivator for cash-out refinances. Debts like credit cards, automotive loans and private student loans typically have higher interest rates than mortgages. Mortgage rates are synced with the federal interest rate, so when rates are low, taking advantage of a refinance could be a smart move for your finances.

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Savings And Investments

Looking to maximize your savings and investments? Even if your house has a high value, you can’t access that money unless you do one of two things: refinance it or resell it. But if you withdraw some of your home’s equity through a cash-out refinance, that money can then be reinvested elsewhere.

Let’s say you choose to invest that money in stocks. Year-to-year returns or those based on individual stocks can be far more volatile, but if you invest in a broad index and have a decent mortgage rate, you stand to make more money by investing your cash than if you chose to blow your savings on one big check to pay off your mortgage early.

If you have other financial milestones you need to save for, like building a college fund or boosting a retirement fund, this can be another great opportunity. That’s the beauty of a cash-out refinance – you can use the freed-up cash to work toward your financial goals, whatever they may be.

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What Are The Pros And Cons Of A Cash-Out Refinance?

Before you apply for a cash-out refi, take the time to weigh the potential pros and cons. This is a big-league financial decision, so run the numbers and base your decision on hard facts.

Pros

  • A large lump sum could potentially help pay for major expenses.
  • You could refinance to a lower interest rate with different loan terms.
  • As opposed to a second mortgage, taking cash out of your primary mortgage means you only have to worry about one monthly payment.
  • Your mortgage interest may be tax-deductible.

Cons

  • You risk foreclosure on your home if you fail to make your monthly payments.
  • You’ll end up paying closing costs on the entire loan amount, typically between 3 – 6%.
  • A new mortgage will mean entirely new loan terms.

When Should You Get A Cash-Out Refinance Loan?

Many of the advantages of a cash-out refinance are impacted by variables that fluctuate with time. Your home’s value, mortgage interest rates and your overall financial situation will all affect the outcome of your refi, so timing matters.

You might be in a good position to consider a cash-out refinance if you meet the following criteria:

  • Your home’s value has increased since the original purchase.
  • You’re eligible for a lower interest rate.
  • You can afford to make higher monthly payments.
  • You want to pay off debt or fund a large expense, like a home renovation.

What Are Alternatives To A Cash-Out Refi?

If you aren’t sold on the idea of a cash-out refinance, don’t fret – there are other options to leverage your home equity. From loans to lines of credit, let’s talk about these alternatives and how they stack up to a cash-out refi.

Home Equity Loan

A home equity loan is a type of second mortgage taken against the equity in your house. Like a cash-out refi, you can take out this type of mortgage for a portion of what you have in equity. Rocket Mortgage® does not offer home equity loans.

But how do home equity loans compare to a cash-out refinance? They both offer lump-sum payouts and can have low interest rates, so why choose one over the other?

The main difference has to do with your monthly payments. While a cash-out refinance will impact your primary mortgage payments, a home equity loan is a second mortgage and therefore adds a second monthly payment. Home equity lenders also typically cover all or most of the closing costs of the new mortgage, but with a cash-out refinance, you’ll need to be prepared to pay those costs yourself.

Home Equity Line Of Credit (HELOC)

Another alternative is a home equity line of credit (HELOC). When you take out a HELOC, it’s split into two periods: the draw period and the repayment period. The draw period typically lasts 5 – 10 years, during which time you can borrow up to 80% of your home’s equity. Rocket Mortgage does not offer home equity lines of credit.

Unlike cash-out refis and home equity loans, HELOCs function similarly to a credit card, so you can borrow cash as you go to avoid borrowing more than you need. When the draw period ends, the repayment period begins. Most of the time the repayment period lasts 10 – 20 years.

When compared with a cash-out refi, HELOCs can be cheaper at face value because you don’t pay all the closing costs associated with a refinance. However, you also don’t get the benefits associated with a refinance, such as potentially lowering your interest rates.

FAQs: Cash-Out Refinance

Before you choose a cash-out refinance, consider these frequently asked questions.

How much money can I get by cash-out refinancing?

The amount of money a borrower can get with a cash-out refinance depends on several factors, including their credit score, the type of mortgage you’re using and the type of property attached to the loan. Generally, the amount you can borrow is capped at 80% of your home’s value.

How long after cash-out refinancing do I get the money?

The average time to refinance a home is 35 – 45 days. After closing, it can take 3 – 5 days for the homeowner to receive their money.

How can a cash-out refinance lower interest rates?

If mortgage rates have gone down since you purchased your home, refinancing may provide an opportunity to lower your interest rates.

Mortgage and refinance rates are also typically more reasonable than those associated with credit cards, so if you need access to a lump sum of money, a refi will be more affordable in the long term.

Does a cash-out refinance affect my credit score?

A cash-out refinance is viewed as a new loan. The change in both your total amount of debt and your credit mix can potentially affect your credit score, but any impact on your credit report should be temporary.

Can I get a cash-out refinance on a second home?

Second homes can be refinanced in mostly the same way as primary residences, with a few small differences. Interest rates will be slightly higher on second homes than those for primary property due to the increased risk for the lender.

You’ll also be able to borrow less of your equity. Where you can borrow up to 80% of the property value on a primary property, cash-out refinances on second homes are capped at 75%.

What’s the difference between a cash-out refinance and a no-cash-out refinance?

The difference between cash-out and no-cash-out refinances mostly comes down to the amount that you refinance. In a no-cash-out refinance, your lender will refinance no greater than your current loan balance, often with the goal of reducing your interest rate or term length. Like other types of rate and term refinances, you aren’t advanced any additional cash with a no-cash-out refi.

Conversely, a cash-out refi allows homeowners with equity in their homes to refinance to a loan amount that is greater than their current balance.

The Bottom Line

If you’re in the market to refinance and want to tap into some equity to fund a home project or consolidate debt, a cash-out refinance could be right for you. But like any financial decision, it’s important to take the time to research and understand your options before you dive in headfirst.

Run the numbers on a different interest rate, closing costs and how it will affect your monthly payment. And if you don’t have the equity you need to achieve your goals, consider other funding types, such as a personal loan.

If your calculations indicate a cash-out refi is a good choice for you, apply to refinance now.

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