Published by Bankrate

Written By: Allison Martin

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Paying down your mortgage helps build equity in your home (one of the reasons a mortgage is considered “good” debt to have). But you don’t have to wait to completely repay your mortgage or sell your home to access that equity. You can convert what equity you have into cash and continue paying off your mortgage with cash-out refinancing.

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What is a cash-out refinance?
Cash-out refinancing replaces your current home mortgage with another, bigger mortgage, allowing you to access the difference between the two loans (your current one and the new one) in cash. The cash amount is based on the value of the equity you’ve built up in your home. The money can go toward virtually any purpose, such as home remodeling, consolidating high-interest debt or other financial needs.

How does a cash-out refinance work?
The process for a cash-out refinance is similar to that of a regular refinance of a mortgage (aka a rate-and-term refinance), in which you simply replace your existing loan with a new one, usually at a lower interest rate or for a shorter loan term, or both. With a cash-out refinance, though, you also withdraw a portion of your home’s equity in a lump sum. So, your new loan amount will be higher — by the amount equal to the equity you’re drawing upon.

For example, say the remaining balance on your current mortgage is $100,000 and your home is currently worth $300,000. In this case, you have $200,000 in home equity. Let’s assume that refinancing your current mortgage means you can get a lower interest rate, and you’ll use the cash to renovate your kitchen and bathrooms.

Lenders generally require you to maintain at least 20 percent equity in your home (though there are exceptions) after a cash-out refinance. So, using our example above, you’ll need to have at least $60,000 in home equity, or be able to borrow up to $140,000 in cash. You’ll also need to pay closing costs, like administrative expenses and appraisal fees (yes, the lender will appraise your home) on the new loan. So the ultimate amount of cash you net from the refinance could end up being substantially less than the actual value of the equity you have.

You tend to pay more in interest after completing a cash-out refinance because you’re increasing the loan amount. Otherwise, the steps for this kind of refinance should be similar to your first mortgage application.

How to prepare for a cash-out refinance
Here’s how you might prepare for a cash-out refinance.

1. Determine the lender’s minimum requirements
Mortgage lenders have different qualifying requirements for cash-out refinancing, and most have a minimum credit score of at least 620 — the higher, the better — although some will accept a credit score as low as 580. The other typical requirements include a debt-to-income ratio below 43 percent (or 50 percent in some instances) and at least 20 percent equity in your home. As you explore your options, take note of the requirements.

2. Determine the amount of cash you need
If you’re considering a cash-out refinance, you’re likely in need of funds for a specific purpose. If you aren’t sure what that is, it can be helpful to nail that down so you borrow only as much as you need. For instance, if you plan to use the cash to consolidate debt, then gather your personal loan and credit card statements or information about other debt obligations, and add up what you owe. If the cash is to be used for renovations, consult with a few contractors to get estimates for both labor and materials ahead of time.

3. Prepare your cash out-refinancing application
Once you’ve shopped around for a few lenders to ensure you get the best rate and terms, prepare all of your financial information related to your income, assets and debt for the application. Keep in mind you might need to submit additional documentation as the lender evaluates your application.

When should you get a cash-out refinance?
“Cash-out refinancing is beneficial if you can reduce the interest rate on your primary mortgage and make good use of the funds you take out,” says Greg McBride, CFA, Bankrate chief financial analyst. Be mindful, that given the current economic climate, it’s highly unlikely you’ll get a lower interest rate unless rates were on the higher end when you took out your current mortgage and your credit score has significantly improved. Still, a cash-out refinance when rates are higher may be beneficial if the funds will be used to improve your home’s value and it’s a cheaper option than a high-interest credit card.

Pros and cons of cash-out refinancing
Before you decide to go through with a cash-out refinance, it’s important to consider the pros and cons.

Pros
You can lower your interest rate: This is the most common reason most borrowers refinance, and it makes sense for cash-out refinancing as well. Obviously, you want to pay as little interest as possible when taking on a larger loan.
Your cost to borrow could be lower: Cash-out refinancing is often a less expensive form of financing because mortgage refinance rates are typically lower than rates on personal loans (like a home improvement loan) or credit cards. Even with closing costs, this can be especially advantageous when you need a significant amount of money.
You can improve your credit: If you do a cash-out refinance and use the funds to pay off debt, you could see a boost to your credit score if your credit utilization ratio drops. Credit utilization, or how much you’re borrowing compared to what’s available to you, is a critical factor in your score.
You can take advantage of tax deductions: If you plan to use the funds for home improvements and the project meets IRS eligibility requirements, you could take advantage of the interest deduction at tax time.
Cons
Your interest rate might go up: A general rule of thumb is to refinance to improve your financial situation and get a lower rate. If cash-out refinancing increases your rate, it’s probably not a smart move.
You might need to pay PMI: Some lenders let you withdraw up to 90 percent of your home’s equity, but doing so might mean paying for private mortgage insurance, or PMI, until you’re back below the 80 percent equity threshold. That can add to your overall borrowing costs.
You could be making payments for decades: If you’re using a cash-out refinance to consolidate debt, make sure you’re not prolonging debt repayment over decades when you could have paid it off much sooner and at a lower total cost otherwise. “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,” McBride says. “Using the cash out for home improvements is a more prudent use.”
You have a greater risk of losing your home: No matter how you use a cash-out refinance, failing to repay the loan means you could wind up losing it to foreclosure. Don’t take out more cash than you absolutely need, and ensure you’re using it for a purpose that will ultimately improve your finances instead of worsening your situation.
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.
Is a cash-out refinance right for you?
Cash-out refinancing can be a good idea for many people.

Mortgage rates are on the rise. Still, the collateral involved in a cash-out refinance — your home — means that lenders take on relatively little risk and can afford to keep refinance rates affordable.

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: Homeowners who use the funds from a cash-out refinance for home improvements can deduct the mortgage interest from their taxes if these projects substantially increase the home’s value.
Investment purposes: Cash-out refinances offer homeowners access to capital to help build their retirement savings or purchase an investment property.
High-interest debt consolidation: Refinance rates tend to be lower compared to other forms of debt like credit cards. The proceeds from a cash-out refinance allow you to pay these debts off and pay the loan back with one, lower-cost monthly payment instead.
Child’s college education: Education is expensive, so tapping into home equity to pay for college can make sense if the refinance rate is lower than the rate for a student loan.
https://www.bankrate.com/mortgages/cash-out-refinancing/

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