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Cash-out mortgage refinance: How it works and when it’s the right option

Bankrate logo Bankrate 5/20/2019 Ellen Chang
a tree in front of a house: Sun setting on a block of houses © P. Eoche/Getty Images Sun setting on a block of houses

A cash-out refinance is another option homeowners can consider when they are seeking additional money for renovations or to pay down their debt.

A cash-out refinance is when a consumer refinances a mortgage into a new one that has a larger amount. The difference between the two mortgages is given to the homeowner in cash. These mortgages are often called a "cash-out refi."

Homeowners need at least 20 percent equity in the home to qualify. This option can be beneficial to consumers who have seen the value of their home rise in recent years.

"Cash-out refinancing is attractive to homeowners that are home rich, but cash poor - in other words, they have too much of their wealth tied up in the home and not enough in liquid assets," says Greg McBride, CFA, chief financial analyst for Bankrate.

Taking the money from the cash-out refi and putting it towards paying down high-interest debt or home repairs can be a financially sound decision.

This type of refinancing can also be attractive when interest rates are low and the money is invested "prudently over a long time frame, such as in a portfolio of quality dividend-paying blue chip stocks," he says.

Using the money to buy disposable items that lose monetary value quickly is not recommended by financial experts.

"It is a very poor use of the money when it is put towards consumption - whether it is vacations, home furnishings or other rapidly depreciating assets such as an automobile," McBride says.

Limit the amount of money you borrow in case real estate values decline and you need to move, downsize or want to sell your home soon and can't afford to wait for prices to rise again.

"If you do a cash-out mortgage refinancing, always leave yourself a healthy equity cushion as a margin of safety," he says. "Maintaining a 20 percent equity cushion gives you some protection from home price declines that coincide with that future point when you're trying to sell the home."

A cash-out refinance allows a homeowner to tap into their home equity by borrowing more than what they owe and is a common choice. Of the 483,000 refinances in the fourth quarter of 2018, some 82 percent were cash-outs - the since the peak of 84 percent in 2006, according to Black Knight Financial Services.

Here is an example of how a cash-out refi works

The value of your home has been increasing and now you only owe $80,000 while the house is worth $250,000.

Let's assume that refinancing your current mortgage means you can obtain a lower interest rate and receive some money to make repairs and updates throughout your house.

To have $50,000 in cash for your project, you could refinance into a loan for $130,000. The new mortgage includes the $80,000 loan balance and the $50,000 in cash.

Alternatives to a cash-out refi

There are three other options you should consider before you start comparing rates on a cash-out refi.

  • Home equity line of credit or HELOC.
  • Home equity loan.
  • Reverse mortgage.

A home equity line of credit or HELOC allows you to borrow money when you need to, which can be useful if you are using the cash for a longer-term renovation project. The interest rate is variable and changes with the prime rate.

A home equity loan gives you a lump sum amount and the interest rate is fixed, which helps homeowners budget for another monthly payment.

A reverse mortgage allows homeowners age 62 and up to draw cash from their homes and the balance does not have to be repaid as long as the borrower lives in the home.

Here are answers to frequently asked questions about cash-out refis.

1. What is a cash-out refinance?

A cash-out refinance lets a homeowner swap their current mortgage into a new one, access their equity and receive cash.

If you've lived in your home for several years, it's likely the value has risen, giving you more equity.

Your original mortgage was $200,000 and after several years of payments, the principal amount has declined to $150,000.

On the other hand, a tax appraisal states your house is now worth $300,000.

When cash-out refinances are conducted, lenders typically allow homeowners to borrow 70 to 80 percent of the home's value. In this scenario, 80 percent of your $300,000 home would be $240,000.

If you opt for that maximum loan amount, you can "cash out" the difference between your new $240,000 mortgage and the $150,000 balance on the old one and receive $90,000.

Since you are obtaining another mortgage, you will have to pay closing costs and fees, which are typically 3 to 6 percent of the total mortgage amount. These costs can be rolled into the new mortgage or the amount can be deducted from what you'll be cashing out in equity.

2. How does a cash-out refinance work?

The proceeds from a cash-out refinance can be used for any purpose. The two most popular reasons homeowners use their home equity is to pay for home improvement or remodeling projects, pay down high-interest credit card debt or cover college tuition.

3. Reasons for a cash-out refinance

Cash-out loans offer several advantages because you can receive a larger amount of money in a lump sum. If interest rates have dropped since you received your initial mortgage, you could save money on paying interest. The difference in interest rates between mortgages and credit cards can be 10 to 20 percent less annually.

4. How much cash can I get?

While lenders typically allow homeowners to borrow up to 80 percent of the home's value, the threshold can vary, depending on your credit score and type of mortgage.

Lenders who offer HHA cash-out refinance loans or refi loans that are insured by the Federal Housing Administration will sometimes let you borrow as much as 85 percent of the value of the home. In addition, VA-backed cash-out refinance loans are available for up to 100 percent of the home's value.

5. What are the rates and fees?

A cash-out refinance means you're signing up for a new mortgage. The closing costs and fees are typically 3 to 6 percent of the total mortgage amount.

Shop around and look for the lender which offers the lowest rate, depending on your credit score.

6. What are the risks?

While using the equity in your home to finance home repairs or upgrades can make economic sense because it will boost the value of your home when you want to sell it, getting a cash-out refi to pay off credit card or take a vacation is not a good move.

If you lose your job and are unable to make payments on your credit card, the lenders do not have any collateral to take.

When you choose a cash-out refi, the collateral is your home. The lender can foreclose on it if you fail to make payments.

You're starting the clock again on your mortgage, which means you could be making payments all over again on a 30-year mortgage. A loan calculator will help you determine the total interest cost of that added debt versus another option. A shorter-term, higher-rate loan could mean paying less in interest overall compared with taking three decades to repay a mortgage with a low interest rate.

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