If you’re looking to tap into your home’s equity, there are a few different options to choose from, including a cash-out refinance. With a cash-out refinance, a larger home loan will replace your current mortgage, and you’ll receive the remaining balance in the form of cash.
How does a cash-out refinance work?
A cash-out refinance may provide a more favorable interest rate and/or different loan terms depending on your current mortgage. The new cash-out refinance loan will enable you to pull out money from your home’s equity. In some cases, a cash-out refinance can go as high as 100 percent of loan to value. The refinance pays off the mortgage balance, and then the borrower may qualify for up to 100 percent of the property value. Any amount beyond the payoff is issued to the borrower in cash, similar to a personal loan.
Cash-out refinance example
Let’s say a borrower initially took out a $137,500 mortgage to buy a home. The value has increased to $175,000 as of today, with a mortgage balance of $125,000 remaining. In this hypothetical scenario, the borrower would be eligible to apply for a loan up to 80 percent of the home’s appraised value, which is $140,000. When subtracting the amount that is still owed on the existing home loan, which is $125,000, a maximum cash-out of $15,000 (not accounting for closing costs) remains.
When to cash-out refinance
If you have enough equity in your home to qualify for a cash-out refinance, the right time to take advantage of a cash-out refinance is entirely up to you. If you find yourself in a situation where you need extra money to take care of a significant expense, a cash-out refinance may be a sensible solution. Everyone has their own reasons for deciding when to cash-out refinance, but one common reason to cash-out refinance is to pay for college. Whether it’s your own tuition or a child’s, for many families, a cash-out refinance is more financially practical than a high-interest student loan. Another common reason for a cash-out refinance is to pay off debts that are tied to higher interest rates, such as high-interest credit card debt. People also often turn to cash-out refinances to take on costly home repairs or home renovation projections. Assuming you have a need for cash and as long as you have enough equity in your home to get the money you need for a specific expense or purchase, the right time to take out a cash-out refinance will always vary from one borrower to the next.
Cash-out refinance vs. HELOC
A Home Equity Line of Credit (HELOC) can offer a similar solution as a cash-out refinance, but they are two separate processes. If you’re looking to borrow against some of your home equity, however, it’s a good idea to thoroughly explore both options when deciding which choice is best suited for you.
A HELOC will not replace your existing mortgage or pay it off; it is an additional loan, and because it’s considered a second loan, it will have its own repayment schedule and terms. A HELOC typically has a draw period of up to 10 years, and during this time, borrowers can withdraw from their available credit whenever they need it. The repayment period will start once the draw period is over, and borrowers must repay the outstanding balance within 20 years. It is also important to note that once the draw period ends and the repayment period begins, borrowers are no longer eligible to withdraw money; it is strictly a repayment period. The interest rate for a HELOC will typically vary based on the current market, although in some cases, a fixed-rate HELOC may be possible. One noteworthy advantage of a HELOC is that you don’t have closing costs; if you do, they are fairly low.
Unlike a HELOC, a cash-out refinance will give you an entirely new mortgage by paying off your existing home loan. Your new mortgage may have terms that differ from your initial loan, and you receive a lump sum of cash once you close on your cash-out refinance. Your new mortgage will pay off your old one first, including any other associated costs with your loan (such as closing costs, which are similar to the closing costs that were paid when you took out your initial mortgage), and you will receive the remaining balance in the form of cash. Similar to your initial mortgage, borrowers can choose between an adjustable rate or a fixed rate for their cash-out refinance.
Cash-out refinance vs. home equity loans
One other option for accessing your home equity is through a home equity loan. Unlike a cash-out refinance, a home equity loan would be an additional loan that allows you to borrow against your equity. Although this means that you’d have two loans to repay simultaneously – your primary mortgage and your home equity loan – you won’t have to pay closing costs with a home equity loan.
Cash-out refinance rates
Just like with traditional mortgages and other types of loans, cash-out refinance rates will vary based on several factors. Some of these factors include your home’s value, your credit rating, and the amount of cash you’re receiving through your cash-out refinance. In general, borrowers can expect rates for a cash-out refinance to be about 0.125 to 0.25 percent higher than a standard (no-cash-out) refinance.
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Cash-out refinance with bad credit
HELOCs often require that borrowers have excellent credit with minimum scores of at least 660 to 700, but cash-out refinancing can provide some flexibility for borrowers with poor credit. This will depend on certain factors, such as the reason(s) for the poor rating and the amount of equity you have in your home. The more equity you have in your home, the more collateral you’d have for a cash-out refinance loan, which helps lenders feel more secure in their decision.
FHA cash-out refinance
If your initial mortgage was an FHA mortgage, you can also qualify for the same unique terms with an FHA cash-out refinance. Borrowers are required to have a minimum of 20 percent home equity (based on a new appraisal) in order to qualify for an FHA cash-out refinance. They must also have an acceptable debt-to-income ratio and favorable payment history. In fact, anyone applying for an FHA cash-out refinance is required to show proof of monthly payments for the previous 12 months, or since the borrower obtained their mortgage, whichever is less. A minimum of six months of payments is also required before obtaining an FHA cash-out refinance. FHA guidelines also enforce a minimum credit score of 580 for eligibility, but minimum credit scores with different lenders may vary.
VA cash-out refinance
Similarly to FHA loans, you can qualify for a VA cash-out refinance if you initially took out a VA mortgage for the purchase of your home. In addition to qualifying for a VA loan when you initially took out your mortgage, you must also meet specific income and credit criteria. You must also be living in the home you’re refinancing through a VA cash-out refinance. If you meet all the criteria for a VA cash-out refinance, you’ll need to apply for a Certificate of Eligibility.