How Does a Cash-out Refinance Work?

A  cash-out refinance replaces your existing home loan with a new mortgage that is higher than your outstanding loan balance.  The difference goes to you in cash and you can spend it on house renovations, debt consolidation, or other financial requirements. You must have equity built up in your house to use a cash-out refinance. 

In comparison to this, the traditional refinancing replaces your current mortgage with a new one for the same balance. This is how a cash-out refinance works:

• You withdraw the difference between the mortgage balance and the home’s value.
• Has slightly higher interest rates due to a higher loan amount.
• Limits cash-out amounts to 80% to 90% of your home’s equity.

To put it differently, you cannot pull out 100% of your home’s equity. If your home is valued at $200,000 and your mortgage balance is $100,000, you have $100,000 of equity in your home. You can refinance your $100,000 loan balance for $150,000, and receive $50,000 in cash at closing to pay for renovations.

Reasons to use a cash-out refinance:

There are significant advantages to using a cash-out refinance over other types of loan products if you need a large amount of cash. Here are a few common reasons to use a cash-out refinance:

• Get a lower interest rate on your mortgage – This is the most typical reason why people do a traditional refinance, and it is logical for cash-out refinancing, too, because you will be taking on a bigger loan and lowering your interest costs.
• You can do value-added home improvements or repairs to your house – Homeowners who use cash-out refinance for these kinds of projects can subtract the mortgage interest from their taxes if these projects considerably increase the home’s value. Additionally, tapping your home’s equity could be cheaper than other types of financing, such as a home equity loan, personal loan, or credit cards.
• Consolidate and pay off high-interest debt – This step might make financial sense, but make sure to do the math first, says Greg McBride, CFA, Bankrate chief financial analyst. “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,” he says.
• Help pay a child’s college tuition – If your adult child needs help paying for college, using your home’s equity to make up the shortfall can be a wise move if student loan rates are much higher than what you can get with a cash-out refinance. If you have substantial debt with double-digit interest rates, then it’s worth it to crunch the numbers to see if you come out better refinancing your house and paying off the debt that way.

 Reasons to NOT use a cash-out refinance:

Cash-out refinancing isn’t always the best move for every situation. Here are some of the cons of a cash-out refinance:

• Raises the interest rate of your current mortgage – 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 substantially, it may not be an intelligent move.
• Reestablishes private mortgage insurance, or PMI – Some lenders let you withdraw up to 90 percent of your home’s equity, but doing so might mean you must pay PMI again after you’ve canceled it. That can add to your overall borrowing costs in the long run over other types of financing.
• Increases the risk of losing your home – No matter how you use a cash-out refinance, failure to repay the loan means you could wind up losing it to foreclosure. Do not take out more cash than you absolutely need, and ensure you’re using it for a purpose that will improve your finances instead of deteriorating your circumstances.
• Lures you to use your home as a piggy bank – Tapping your home’s equity to pay for extravagant holidays or purchases shows an absence of discipline over your spending behaviors. If it is a trouble for you to get your debt or keep your spending habits under control, consider seeking help through a nonprofit credit counseling agency.

Debt consolidation does not have to be that difficult

Do you still have concerns? Despite the precautions listed, now might be a good time for a cash-out refinance. Here’s why:

• When home prices surge, this tends to mean home equity you can tap into.
• With stagnant incomes in several industries and a rise in consumption, some people may find themselves in need of money, especially around the vacation period.
• The recent tax reform has restricted homeowners’ choices when it comes to using home equity. This implies a cash-out refinance with a first-lien mortgage may be very helpful.

Don’t worry, you always have options in how to manage your debt sensibly. To know more about using a mortgage to consolidate high-interest debt, give Affiliated Mortgage a call right now!