If you have equity in your mortgage, there are several things you can do to take advantage of it. 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?
Here, we’ll break down the ins and outs of the cash-out refinance, outline what it’s for and talk about some alternatives.
What Is A Cash-Out Mortgage Refinance?
A cash-out refinance is a handy way to convert your home’s equity into cash while refinancing your mortgage at the same time. In addition to lowering your interest rate, a cash-out refi can help you fund personal projects or consolidate debt.
This means refinancing to a higher amount than your existing loan, allowing you to use the cash difference on whatever you need to.
How Does A Cash-Out Refinance Work?
A cash-out refi requires three things: a good credit score, an acceptable debt-to-income ratio and a decent amount of home equity. Here’s a little more detail on each:
Credit score: A cash-out refi will require a credit score of at least 620.
Debt-to-income ratio: An acceptable debt-to-income ratio (DTI) for a cash-out refi is no higher than 50%.
Home equity: Your home should have a sizable amount of equity built up in order to take full advantage of a cash-out refinance.
Let’s use an example to talk about how this works. Say you have a 700 credit score, 35% DTI and $150,000 left to pay on your mortgage. Your home is currently worth $230,000, meaning you have $80,000 in equity.
You want to dip into that equity to pay off credit card debt. You decide to go with a cash-out refi, refinancing your $150,000 mortgage to $165,000. You can then take the difference in cash and use it on your credit card bills.
How Can A Cash-Out Refinance Lower Interest Rates?
If mortgage rates have dropped since you bought your home, any type of refinancing could get you a lower rate. Refinancing to a lower interest rate can save you a considerable amount of money over the life of the loan. Cash-out refis also tend to offer lower interest rates than other financing options, such as a home equity loan.
What Is A No Cash-Out Refinance?
A no cash-out refinance is a kind of rate and term refinance used primarily to adjust a current mortgage without gaining additional cash. This is a typical type of refinance. You can use it to get a lower interest rate, more favorable loan terms, stop paying mortgage insurance and switch to a different loan type, such as from an adjustable-rate mortgage to a fixed-rate mortgage.
How Can A Cash-Out Refi Help You?
Now that we’ve gone over the things that can make a cash-out refi an attractive loan option, how might you use one to accomplish your goals? Here are just a few ways the value of your home might come in handy.
Home Improvement And Renovation Projects
One popular way to use a cash-out refinance is for home improvements. If your home is in need of major updates or renovations, a cash-out refi may be a viable option. Since you’re adding onto your mortgage, consider a cash-out refi when you’re making expensive changes.
Things like a new roof, solar panels, building an addition or large kitchen remodels may be good uses of cash-out refi money.
Debt consolidation can be a good reason to go with a cash-out refi. Things like credit cards, car loans and private student loans all typically have higher interest rates than mortgages. Mortgage rates are in sync with federal interest rates. Currently, the federal funds rate is exceptionally low, so taking advantage of this by refinancing now could be a smart move for your finances.
Maximize Your Savings And Investments
The last great reason you might take a cash-out refi is to maximize your savings and investments. If your house has a ton of value, you can’t access that money unless you do one of two things: refinance your home or sell it. Let’s look at the potential benefit of refinancing your house.
Let’s assume mortgage rates are in the low 5% range. Warren Buffett is often cited as saying that over the long term (10 years or more), the average return for the stock market is around 7%. You should only rely on this role if you’re a buy-and-hold investor in a broad market index. Year-to-year returns or those based on individual stocks can be much more volatile. However, if you invest in a broad index and have a decent mortgage rate, you can make more money by investing your cash rather than blowing your savings on one big check to pay off your house. It frees up your cash for other opportunities.
While 99.99% of us aren’t likely to become billionaires with a reported 1.05% interest rate on our mortgage, because interest rates are typically lower for mortgages than for most other loans, it can make sense to have a mortgage for most people. You can also write off the interest on your taxes.
With that in mind, you can use a cash-out refinance to build a college fund or boost a retirement fund. You can use it for building an investment portfolio. This can be flexible for your financial goals.
Alternatives To A Cash-Out Refinance
A cash-out refinance isn’t the only home equity loan option out there. 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 second mortgage taken against the equity on your house. You can take out this mortgage for a portion of what you have in equity. They have lower interest rates than a personal loan. 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. The main difference is that cash-out refis are one loan, where a home equity loan is a second mortgage. Also, home equity lenders usually pay all or most of the closing costs of the new mortgage.
HELOC (Home Equity Line Of Credit)
Another alternative is a HELOC (home equity line of credit). When you take out a HELOC, it’s split into two periods: the draw period and the repayment period. A draw period typically lasts 5 – 10 years, where you can borrow up to 80% of your home’s equity. Rocket Mortgage® does not offer home equity lines of credit.
The repayment period starts when the draw period ends. Most of the time the repayment period lasts 10 – 20 years. When compared to a cash-out refi, HELOCs can be cheaper at face value. That’s because you don’t pay all the closing costs associated with a refinance. However, you don’t get the benefits associated with a refinance, which could mean a lower rate and/or changing your loan terms.
Pros And Cons Of A Cash-Out Refinance
Before applying for a cash-out refi, you should run the numbers and weigh the pros and cons. This is a big-league financial decision, so base it on hard numbers, how much equity you have and what you’re using the money for.
- You’ll get a better interest rate because the lender gets first position on your title.
- You could refinance to a lower rate with different loan terms.
- Taking cash out of your primary mortgage means you only worry about one monthly payment.
- Your mortgage interest may be tax-deductible.
- You can potentially take out a large lump sum to pay other, more pressing costs.
Is A Cash-Out Refinance Right For You?
Now that we’ve gone over what a cash-out refinance is and the benefits, it’s time to determine if it’s right for you. There are really two questions you need to ask yourself in order to make that decision.
Do You Have Enough Equity To Accomplish Your Goal?
As a hedge against risk, one common requirement for a cash-out refinance is that you leave 15% – 20% equity in your home after the refi. Because of this, it’s important that before you take cash out, you determine whether you have enough equity to accomplish your goal, whether it be remodeling, debt consolidation or anything else.
The one option that doesn’t require you to leave any equity in your home is a VA loan, which allows you to take out up to the full value of your home, assuming you meet the qualifications. VA loans are only available for eligible active-duty military members, reservists, veterans and surviving spouses.
Are You Comfortable Using Your Home Equity For This Purpose?
Finally, you need to decide whether your goal is something you want to use the value in your home for. Let’s break that down.
Although most states don’t enforce a minimum loan amount, when you get to mortgage amounts that are extremely low, it may make more sense to take out a personal loan by the time closing costs are factored in. While this may not be a factor if you already have an existing mortgage, it could come into play if you’re taking a small loan on a home that’s been completely paid off in the past.
Along a similar vein, some people who are close to paying off the mortgage might consider an alternative funding source if they don’t want to go through refinancing again. Our friends at Rocket Loans® offer personal loans that may be helpful in this situation.
The Bottom Line
If you’re in the market to refinance and want to tap into some equity for a home project or to consolidate debt, a cash-out refinance could be right for you. Run the numbers on a different interest rate, closing costs and how it will affect your monthly payment. If you don’t need a large lump sum or don’t have the equity to get what you need done, consider other funding types, such as a personal loan.
Ready to pursue a cash-out refinance? Apply today at Rocket Mortgage®.