The Power Of A Cash-Out Refinance: How It Works and When To Do It

Paying down a mortgage helps build equity, which is one of the reasons why owning a property is seen as a good investment. But you don’t have to wait until you’ve paid off your mortgage or sold your home to use your equity.

With cash-out refinancing, you can turn your home’s equity into cash and keep paying off your mortgage.

What is a Cash-Out Refinance?

A cash-out refinance is a mortgage refinancing option that replaces your current home loan with a bigger mortgage, allowing you to take advantage of the equity you’ve built up in your home and access the difference between the two mortgages (your current one and the new one) in cash.

The cash can be used for almost anything, like home renovations, paying off high-interest debt, or other investments. In real estate, refinancing is a common way to replace an old mortgage with a new one that usually has better terms for the borrower.

By refinancing a mortgage, you may be able to lower your monthly payments, negotiate a lower interest rate, change the loan terms, remove or add borrowers, and, in the case of a cash-out refinance, get cash from the equity in your home.

How does a Cash-Out Refinance work?

A cash-out refinance allows you to use your home as collateral for a new loan as well as some cash, creating a new mortgage for a larger amount than what is currently owed.

The cash-out refinance process is similar to the process you undergo when you buy a home.

After you know you meet the requirements, find a lender willing to work with you, the lender assesses the current mortgage’s terms, the balance needed to pay off the loan, and the borrower’s credit profile, submit an application, and documentation to underwriting, get approval and wait for your check.

Pros and Cons of a Cash-Out Refinance

Before you decide to do a cash-out refinance, you should carefully consider the pros and cons.

Pros

You can take advantage of tax deductions: If you plan to use the money to make changes to your home and the project meets the requirements set by the IRS, you could use the interest deduction when you file your taxes.
Your cost to borrow could be lower: Cash-out refinancing is often a cheaper way to borrow money because mortgage refinance rates are usually lower than rates on personal loans or credit cards. Even with the costs of closing, this can be very helpful when you need a significant amount of money.
You can improve your credit: If you use the money from a cash-out refinance to pay off debt, your credit score could go up if your credit utilization ratio goes down. A big part of your credit score is how much you’re borrowing compared to how much credit you have available.
You can lower your rate: This is the most common reason most borrowers refinance, and it makes sense for cash-out refinancing as well because you want to pay as little interest as possible when taking on a larger loan.

Cons

Your rate might go up: As a general rule, refinancing is a good way to improve your finances and get a better rate. If your rate goes up after cash-out refinancing, it’s probably not a good idea.
You might be tempted to use your home as a piggy bank: Tapping your home’s equity to pay for things like vacations indicates a lack of discipline with your spending. If you’re struggling with getting your debt or spending habits under control, consider seeking help through a nonprofit credit counseling agency.
You might need to pay PMI: Some lenders will let you take out up to 90% of your home’s equity, but you may have to pay private mortgage insurance, or PMI, until you’re back below the equity threshold of 80%. That can make your overall loan costs go up.
You could be making payments for decades: If you’re using a cash-out refinance to pay off debt, make sure you’re not prolonging debt repayment for decades when you could have paid it off much sooner and at a lower total cost. Keep in mind that the repayment on whatever cash you take out is being spread over 30 years, so paying off higher-cost credit card debt with a cash-out refinance may not yield the savings you’re thinking.
You have a greater risk of losing your home: No matter how you use the cash from a cash-out refinance, if you don’t pay back the loan, you could lose your home to foreclosure. Don’t take out more cash than you need, and make sure you’re using it in a way that will help your finances in the long run instead of hurting them.

Example of a Cash-Out Refinance

Say you took out a $200,000 mortgage to buy a $300,000 property, and after many years, you still owe $100,000 on that mortgage. Assuming that the house is still worth $300,000, you have at least $200,000 in home equity. If interest rates have gone down and you want to refinance, the underwriting could let you borrow up to 80% of the equity of your home.

Many people wouldn’t necessarily want to take on the future burden of another $200,000 loan, but having equity can help the amount you can receive as cash. Let’s say your lender is willing to lend out 75% of your home’s value. For a $300,000 home, this would be $225,000. You need $100,000 to pay off the remaining principal. This leaves you with $125,000 in cash.

If you decide to only get $50,000 in cash, you would refinance with a $150,000 mortgage loan that has a lower rate and new terms. The new mortgage would consist of the $100,000 remaining balance from the original loan plus the desired $50,000 that could be taken out in cash.

In other words, you can assume a new $150,000 mortgage, get $50,000 in cash, and begin a new monthly installment payment schedule for the full amount. That’s the advantage of collateralized loans. The disadvantage is that the new lien on your home applies to both the $100,000 and the $50,000 since it is all combined together in one loan.

The Bottom Line: Is A Cash-Out Refinance Right For You?

Many people can benefit from cash-out refinancing.

At the moment, mortgages have some of the lowest interest rates of any loans. Because your home is used as collateral, lenders don’t have to take on much risk and can keep interest rates low.

That means that cash-out refinancing is one of the cheapest ways to pay for large expenses. Most homeowners use the proceeds for the following reasons:

Home improvement projects
If a homeowner uses the money from a cash-out refinance to make home improvements that raise the value of the home, they can deduct the mortgage interest from their taxes.

Investment purposes
Cash-out refinances give homeowners access to money that they can use to save for retirement or buy another investment property.

High-interest debt consolidation
Rates for refinancing tend to be lower than rates for credit cards or other types of debt. With the money from a cash-out refinance, you can pay off these debts and pay back the loan with one, lower-cost payment each month.

Child’s college education
Education is expensive, so tapping into home equity to pay for college can make sense if the refinance rate is much lower than the rate for a student loan.