What is cash-out refinancing?
Cash-out refinancing means you are taking out a new mortgage loan of an amount higher than the outstanding balance amount of your current mortgage. Thereby, you can withdraw the difference amount in cash and use that money for fruitful purposes like home renovation, debt consolidation, etc.
Usually, people refinance their existing mortgages for a lower interest rate or a shorter loan term or both!
So, you might plan to opt for a cash-out refinance if you are in dire need of money! But you know what? Every loan has its pros and cons. So, before you proceed, let’s weigh the pros and cons of a cash-out refinancing.
- 1. Save money on interest payments
Cash-out refinance offers a much lower interest rate than that of an equity loan. So, if you have taken out a mortgage loan when the interest rate was high, you can refinance it with a new mortgage when the interest rate has dropped by a substantial amount. Thereby, you can save money on your interest payments.
- 2. Get tax benefits
If you use the loan amount for home improvement works, you might be eligible for tax breaks. So, eventually, that will bring down your loan costs! However, make sure that the home improvement work should add value to your home (to increase your property’s cost) like building a new bathroom, an additional garage, or doing a kitchen renovation, fencing, etc. By doing so, you can recover the renovation costs if you sell your home in the future.
- 3. Increased credit score
Taking out a cash-out refinance loan can help you to improve your credit score! If you consolidate your high-interest debts by refinancing, your credit utilization ratio is likely gonna reduce. And eventually, your credit score can improve. But remember, you need to make timely payments on your new mortgage loan, too.
- 4. Longer repayment period
You can get a longer repayment period when your current mortgage loan is replaced by a new mortgage. So, your monthly mortgage payments might get reduced as the interest rate of the new mortgage is likely to be less.
- 1. Risk of foreclosure
If you fail to make payments on time, your home will be at risk. Because you are keeping your house as the collateral. The lenders can put a foreclosure on your home, and this way, you may lose your shelter.
- 2. Increased monthly payments
Opting for a cash-out refinance loan can increase your mortgage payments. The reason being, you are taking out a loan of a higher amount than your current outstanding balance amount.
- 3. Shelling out closing costs
You will have to pay up-front closing costs. Usually, the closing costs range within 2% to 5% of the mortgage amount.
- 4. Pay for private mortgage insurance
If you are planning to take out a loan of an amount of more than 80% of your home’s value, you will have to pay for private mortgage insurance (PMI). The PMI usually ranges between 0.3% to 1.5% of the loan amount. So, it can increase your borrowing costs to some extent!
Do you lose equity when you refinance?
Well, the answer is YES!
Let’s say, you owe a mortgage loan of $150,000. And you have already paid off $60,000 (your equity). So, you can refinance the remaining balance of $90,000 for $120,000 and keep that extra $30,000 for making some good use of it. But by doing so, you have reduced your equity in your home by $30,000 ($60,000 – $30,000).
However, most of the lenders will allow you to tap up to 80% of the equity in your home. So, you can retain at least 20% of your home equity.
What credit score is needed for a cash-out refinance?
You need to have a decent credit score when you are taking out a loan. And a cash-out refinance loan is no exception.
If you want to take out a cash-out refinance loan, you need to have a credit score of at least 620 or higher.
However, if you had taken out an FHA (Federal Housing Administration) loan, the minimum credit score required ranges from about 500 to 580. And if you are eligible for VA (Veterans Affairs) benefits, you can refinance your current VA mortgage loan with an interest rate reduction refinance loan (IRRRL). Usually, VA refinance loans don’t require any credit score to qualify for it.
How much money can I get from a cash-out refinance?
Depending on your credit score and mortgage type, you can opt for a cash-out refinance loan of about 80% of the value of your home.
To find out how much money you can take out from a cash-out refinance loan, you need to calculate the:
- 1. Remaining outstanding balance amount of your current mortgage
- 2. Appraised value of your home
- 3. Loan-to-Value (LTV) ratio of your home
- 4. Retained equity you need to maintain according to the lender
Let me help you with an example!
Let’s say, you have taken out a mortgage of $300,000 to buy your home. Currently, you have an outstanding balance of $150,000 to pay off. So, your equity in your home is $150,000.
Your lender will calculate the Loan-to-Value (LTV) ratio of your home to determine the maximum amount of cash-out refinance loan that you can take out!
LTV ratio of your home = Mortgage amount / Appraised value of your home
Let’s consider that the appraised value of your home is $400,000. And the lender has set a maximum LTV of 80% and eventually, the retained equity at 20%.
Therefore, the loan amount will be = 80% of $400,000 = $320,000
The amount of retained equity will be = 20% of $400,000 = $80,000
So, you can take out a cash-out refinance loan of ($320,000 – $150,000) = $170,000.
However, if you had taken out FHA loans previously, you can now take out a cash-out refinance loan of up to 85% of the value of your home. Besides, if you are VA qualified, you can take out a loan of up to 100% of your home’s value.
Does refinancing a mortgage loan hurt your credit?
Well, opting for a cash-out refinance loan doesn’t necessarily hurt your credit score! But it can affect your credit score adversely in the following circumstances, like:
1. While applying for a refinance loan, your lenders will make a hard inquiry on your credit report. And it can lead to a slight drop in your credit score.
When you are shopping around for a refinance mortgage, multiple inquiries may be generated. Usually, these multiple inquiries are considered as a single inquiry for a certain time. It depends on the lenders, but in most cases, it’s about 15 to 45 days. In this period, you can shop around for a new loan and find the best deal for yourself.
2. Opting for a cash-out refinance loan means you are taking out a new mortgage loan to pay off your current mortgage. That means you are closing an old credit account. Remember, the length of your credit history comprises 15% of your credit score. So, closing an old account can reduce your credit score.
However, you can keep your oldest credit card active to maintain a decent credit score.
3. It will take some time to refinance your mortgage. So, remember to make payments on your existing mortgage on time. Otherwise, late payments will be marked and that will hurt your credit score.
What can you do with a cash-out refinance?
You can take out a cash-out refinance loan for various fruitful reasons like:
- 1. Saving money on interest payments
If you have taken out a mortgage loan when the interest rate was high and the present mortgage rate is low, you can refinance your mortgage to save money on interest payments.
- 2. Paying off high-interest debts
Do you have any high-interest debts to pay off? If yes, you might be losing a substantial amount of your paycheck to pay them off! So, by opting for a cash-out refinance loan, you can consolidate your multiple high-interest debts into single monthly payments.
Thereby, you have to shell out much less for your interest payments as the interest rate of the new loan is usually much lower.
And you can pay off your multiple debts with ease by making a single payment every month.
- 3. Renovating your home
If you need funds for any improvement in your home, the cash-out refinance loan will be the best bet! You can renovate your home with the loan amount to increase the value of your home. Moreover, it can help you to deduct interest payments from your taxes if the renovation work increases the value of your home.
How long does it take to get money from a cash-out refinance loan?
Usually, the process of cash-out refinance loans takes about 30 to 45 days. It depends on the lender. So, you can talk to your lender about how long it will take to complete the entire process and when you will receive the loan amount. Opting for a cash-out refinance loan can be a lengthy process as it may take some considerable time.
Should I opt for a cash-out refinance to pay off debt? Is it a good idea?
We all don’t like carrying debts in our lives! And I believe that you are not an exception. Because you need to sacrifice a substantial part of your paycheck to pay off debt. And if you have an unsecured debt to pay off, it might be a more cumbersome process. The reason being, incessantly high-interest rates. One of the common examples of unsecured debt is credit cards. The APR (Annual Percentage Rates) of credit cards are much higher. And if you have multiple credit card debts, the situation may be worse!
So, opting for a cash-out refinance loan to pay off your debts is indeed a good idea! You can save money on your interest payments and you can repay the loan over a longer period of time. And you can bundle multiple payments into a single payment every month!
Thereby, a cash-out refinance loan can help you to pay off your debts with ease and work on your financial goals asap!
However, make sure to make payments for your new mortgage loan on time. Otherwise, you can lose your home as your lenders can foreclose your home due to nonpayment. Besides, be prepared to shell out money due to closing costs which are about 2% to 6% of the loan amount.
So, the bottom line is, taking out a cash-out refinance loan is a good idea for home improvement, debt consolidation, and other fruitful purposes. But I would suggest not to tap into your home equity randomly. Because you will put your home at stake.
So, you can look for some other alternative options to consolidate your unsecured debts; you can consolidate credit card debts on your own and get rid of them!
Lastly, try to organize your finances in a better way so that you don’t need to tap into your home equity!
What do you think?