Cash-Out Refinance Mortgage
A cash-out refinance mortgage is one of many options available to homeowners seeking to consolidate debt or make a large purchase. It uses their existing home equity as leverage and offers a newer one in place of their existing loan.
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In this guide, we’ll look at the options available to you when applying for a cash-out refinance mortgage, including how you can spend this money, how much you can get, and how quickly it can be repaid, as well as the many pros and cons.
What is a Cash-Out Refinance Mortgage?
A cash-out refinance mortgage, often shortened to “cash-out refi”, is a mortgage loan that replaces your current mortgage and increases the amount that you owe. The difference between your current mortgage and your previous mortgage is then released as a cash sum, which you can use to make home improvements, start a business or consolidate debts.
You can spend your cash lump sum however you choose, but choose wisely—this is not a sum you want to fritter away. Using a cash-out refinance mortgage to fund a vacation or an expensive purchase will create problems for you further down the line, swapping valuable home equity and a long-term commitment for a short-term luxury.
Try to limit your spend to the following:
- Home Improvement: Real estate is a sound investment and one that generally appreciates with age. When you use your cash-out refinance mortgage to improve your home (making renovations, adding a new building, etc.,) you can increase the short-term value and growth potential, ensuring that your house is worth significantly more when your new loan is eventually repaid.
- Repay Credit Card Debt: Debt consolidation is a great option for that cash lump sum. This is true for any debt but it’s at its most useful for high-interest debts like credit cards. These debts charge astronomical rates and if you’re not paying more than the minimum each month, you’ll end up repaying much more than the initial debt. By clearing these debts, you could be swapping multiple high-interest rates for one low one, saving you thousands over the term.
- Invest: Got your eye on a brand-new investment property but don’t have the capital to complete the purchase? A cash-out refinance mortgage can provide you with the funds you need, adding a new deed to your growing property empire. If you choose wisely, that property could be worth more than the cost of your loan by the time it’s repaid.
- Build a Business: 9 out of 10 businesses fail—it’s a cliché statement, but it’s a cliché because it’s true. Using your home to invest in a business is a risky strategy, but if that business succeeds it’ll look like a sound investment and it could set you up for life.
Terms of a Cash-Out Refinance Mortgage
There are cash-out refinance options available for all types of loan, each of which has its own terms and eligibility criteria:
- VA Cash-out Refinance: You can apply for VA refinancing with a VA loan or a conventional loan. You need to have served in the military and have a credit score of at least 620.
- FHA Cash-Out Refinance: You need equity of at least 15% and a score of at least 580 to apply for FHA refinancing.
- Conventional Cash-Out Refinance: You must have at least 25% equity in your home, with most lenders only accepting homeowners with credit scores of 620 or higher.
How Long does it Take to Apply?
A cash-out refinance mortgage generally takes between 4 and 6 weeks, providing there are no delays and you provide the lender with all the information they request in a prompt and timely manner. You will be asked for details such as:
- Proof of Income: Tax forms and pay stubs need to be supplied. The lender may also request bank statements, which they may use to check your debt-to-income ratio. Also known as a DTI, this is the amount of debt that you have when compared to your income.
- Details of Debt: What the lender doesn’t get from your bank statements and credit check needs to be supplied directly. They will ask for details of all debt payments and balances to judge how much is leaving your account every month and whether this will have any impact on your future finances.
- Homeownership Documents: The lender will seek proof that you actually own the property. They may ask for mortgage documents as well as proof of insurance.
Pros and Cons of a Cash-Out Refinance Mortgage
A survey conducted just a couple of years ago found that close to half of all homeowners had used a cash-out refinance mortgage to tap into their home equity and get some much-needed cash. But is this option right for you? Take a look at these pros and cons to find out.
Pro: Low-Interest Rates
The biggest benefit of a cash-out refinance mortgage, and any secured loan for that matter, are the low-interest rates. Unlike unsecured credit cards and payday loans, secured loans have sizeable collateral behind them so the lenders can afford to offer favorable rates. This provides many benefits to the borrower and means they can get very low rates.
Pro: Switch from ARM
If you have an adjustable-rate mortgage then a cash-out refi can help you switch to a fixed-rate mortgage, one that offers more beneficial terms and provides you with some stability over the long-term.
Pro: Additional Options
A cash-out refinance mortgage could save you a lot of money if you have mounting debts and no means of repaying them. It can also be a better option from personal loans and lines of credit if you’re seeking to make home improvements or pay for an education.
Many homeowners have used cash-out refinance mortgages to fund their children’s and their grandchildren’s college tuition, negating the need for costly student loans.
Pro: A Lot of Money
Very few loans and lines of credit can give you the sort of money provided by a cash-out refinance mortgage. You can get a loan of over $100,000 with relative ease, something that simply wouldn’t be available to you via traditional loans.
Pro: Tax Breaks
Although they are not as beneficial as they once were, there are still tax breaks available to individuals who use cash-out refinance mortgages to fund home improvements.
Con: Increased Payments
A cash-out refinance mortgage will greatly increase the total sum that you repay over the lifetime of the loan, potentially adding tens of thousands of dollars to the balance. This is why it should only be considered if the money is being used to add value or grow your net worth.
Con: Foreclosure Risk
As is the case with any secured debt, failure to meet the monthly payments could result in seizure of the asset. The lender won’t hesitate to foreclose if you stop making payments, something that simply won’t happen with unsecured loans.
Cons: Closing Costs
Mortgages don’t come cheaply, and you will be required to pay closing costs when the loan is settled. These closing costs are fixed as a percentage of the balance and can be added to the loan or paid in full. In either case, it greatly increases the cost.
How Much Can You Borrow?
The total amount that you can borrow with a cash-out refinance mortgage will depend on your home equity, your credit history, and your debt-to-income ratio. The value of your home will also be factored into the equation. It will be appraised by the lender to determine how much it’s worth and from this, they will decide how much you can borrow.
To improve your chances of getting a positive appraisal, it’s worth spending some time improving your home. Fix any leaks, replace anything that’s broken, and give everything a good clean to ensure it is spick and span for the appraisal.
You can also work on building your debt-to-income ratio, which is used to determine if you can meet the monthly payment on the loan, and your credit score, which may be a deciding factor if it’s too low.
How Long Does It Take to Repay?
You can stretch your mortgage to a period of 15 or 30 years. Doing so will greatly increase the amount that you repay in total, but it could also reduce your repayments in the short-term, which is ideal if you’re funding a property purchase or looking to reduce your debts.
Should You Get a Cash-Out Refinance Mortgage?
It’s important to weigh up the pros and cons before making your decision on a cash-out refi. If you have spent years repaying your mortgage loan and have built up sizeable equity and a strong credit score, it’s tempting to leverage that to acquire a sizeable cash sum. However, if you’re using that money to buy something that has little to no inherent value or will depreciate rapidly, it’s generally not recommended.
If you’re using it to repay debts, on the other hand, it’s worth looking into. You can do the sums yourself to see how much a cash-out refi will save you. Use a credit card debt calculator to see how much your current debts are costing you and then compare this to how much a cash-out refinance mortgage would cost you.
You can use the same methods to consolidate personal loan debt and other unsecured and secured debts. However, because credit cards charge extortionate interest rates, you’ll generally save a lot more clearing credit card debts than you will with other debts.
Can You Get One with Bad Credit?
It is possible to get a cash-out refinance mortgage with Fair or Good credit. However, if you have really bad credit then you may struggle, especially if you have a poor debt-to-income ratio. This is true even if you have a lot of home equity. Lenders still want the assurance that you will meet your monthly payment obligations as repossession is costly and not something they are willing to jump into.
As is the case when you apply for your mortgage first-time around, your credit will also impact how favorable your mortgage terms are and what sort of options are available to you. Bad credit could leave you with high mortgage rates. These, when added to the closing costs, could make that cash sum decidedly less appealing and leave you with a debt that will impact your life for years to come.
If you have bad credit and need a small loan, a look at our section on “alternatives to a cash-out refinance mortgage” to find a better option. Alternatively, work on rebuilding your credit, gaining more equity, and improving your debt-to-income ratio. It may only take 6 to 12 months of careful credit building to get the best cash-out refinance rates.
Alternatives to a Cash-Out Refinance Mortgage
A cash-out refinance swaps equity for cash—a fair trade and a simple one. You get the money you need and in exchange, you switch mortgage rates and increase the term of your loan. But if you don’t need that much cash, don’t have a good credit score or are simply looking for a better deal, what are your options?
Here are a few alternatives.
Home Equity Loan vs Cash-Out Refinance Mortgage
A home equity loan works in a similar way to a cash-out refinance mortgage. The main difference is that a cash-out refinance mortgage replaces your existing mortgage with a new one, while a home equity loan takes out a second mortgage against your existing equity. There is no “better” option, as it will depend on personal preferences, as well as credit history and debt.
Reverse Mortgage vs Cash-Out Refinance Mortgage
A reverse mortgage is a great option when you need cash and in many cases, it is the better option. There are no monthly payments to make and you don’t have to repay the loan taken out against your equity until you die or sell the house. However, there are strict terms attached to these loans, including an age requirement (typically over 62) and an insistence on it being your main residence.
If you’re over 62 and have built up some substantial equity, take a look at our reverse mortgage calculator to see how much you can borrow and to learn more about the process.
HELOC vs Cash-Out Refinance
A Home Equity Line of Credit or “HELOC” is a line of credit secured against your home. It’s like having a credit card with a large limit secured against your home.
There are two stages: In the first, you use the credit offered to you and in the second you repay it. There are low rates available and it’s a great option for homeowners who don’t need a huge cash sum and have multiple smaller, consecutive payments to make.
Loans vs Cash-Out Refinance Mortgage
It’s very rare that you’ll be offered a loan large enough to compare to a cash-out refinance mortgage or a home equity loan. What’s more, because these loans are unsecured, the interest rates will be much higher, so you’ll pay much more over the term, even when closing costs have been accounted for.
However, if you only need a small sum, it may be better to apply for a personal loan and focus on repaying this as quick as you can. By increasing minimum payments, you can shorten the term of the loan and reduce the amount that you repay.