Cash Out Refinancing: How it Works

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American homeowners have nearly $20 billion in real estate equity, according to the Federal Reserve.

That’s a lot of money homeowners have access to, and thanks to record low mortgage rates, it’s cheaper than ever for homeowners to tap into their home’s equity with a cash-out refinance. 

Of course, just because you have access to this cash doesn’t mean you should.

As with any mortgage refinance, there are upfront fees to pay and you’ll want to make sure you are in a secure financial position. And as low as the average mortgage rates are in 2020, you’ll only qualify for the best interest rates if you have the best credit score. Lenders are also more hesitant to issue cash-out refinancing amid unemployment levels that rose more in three months of the pandemic than in two years of the Great Recession.

That said, if you have enough equity in your home, and the ability to tap into it, a cash-out refinance is a financial tool worth having at your disposal. Here’s how it works and what you should pay attention to if this is something you’re considering.

What Is a Cash-Out Refinance?

A cash-out refinance is when you pay off your existing home loan by getting a new one that’s larger than what you currently owe—and get a check for the difference. This is only an option if you have enough equity in your home. If you’re dealing with a conventional conforming mortgage, your new loan will be capped at about 80% loan to value, says mortgage educator Jennifer Beeston. 

For example, if your home is worth $250,000 and you have $100,000 left on your mortgage, that means you have $150,000 in equity. You could do a cash-out refinance for up to 80% of your home’s value, which in this case would be $200,000. But that wouldn’t quite leave you with a $100,000 payout. This is because closing costs will be taken out of what you’d get back and could be up 3 to 6% of the total loan value.

Home Value Homeowner’s Equity Amount Owed on Mortgage New Cash-Out Refinance Refinance Amount Less Amount Owed Closing Costs Cash Paid Out to Homeowner
$250,000 150,000 100,000 200,000 $100,000 $6,000 – $12,000 $88,000 – $94,000

A cash-out refi will typically have a higher interest rate and more strict lending guidelines than other types of mortgage refinancing. This is because a cash-out refinance is more risky for the lender. So if you don’t have a good credit score it might not be an option for you.

When Is a Cash-Back Refinance a Good Move?

As with any mortgage refinance, a cash-out refi makes sense if it can save you money. But a cash-out refinance won’t get you the lowest interest rate or smallest monthly payment. When you’re doing a cash-out refinance versus a normal refinance, the rate is likely going to be a bit higher, Beeston says. It’s considered a riskier loan because you’re taking cash out.

But a cash-out refinance can still make sense even if your monthly mortgage payments increase, as long as you’re saving somewhere else as a result.

Consolidating Debt

With how low refinance rates are right now, this is a potentially great opportunity to consolidate high-interest consumer debt – if you have enough equity in your home. By using the cash from a refinance to pay off other debts like credit card balances and auto loans, which have higher APRs than your new mortgage, you are effectively consolidating these payments into your new lower-interest mortgage payment. 

Besides the lower interest rate on your other debt, there is also a potential for tax savings with a cash-out refinance. You may be able to deduct a certain amount of the interest you pay on your mortgage to reduce your taxable income, which isn’t the case with the interest you pay on other loans. How much you save on taxes will vary depending on your individual circumstances, so it’s something to bring up with your tax professional.

Home Renovations

With people spending more time than ever in their homes, cashing out equity to make home improvements can also make sense, because it can be a cheap way to finance the expense. This is especially true if these upgrades add value to your home. 

Pro Tip

A cash-out refinance can be a great way to consolidate higher-interest debt, but there are upfront fees, so it doesn’t make sense for small debts.

When Should You Pass on a Cash-out Refinance?

You may have the credit score and home equity to qualify for a cash-out refinance, but it could still be a bad move. Just because a mortgage lender is willing to lend you a certain amount of money, doesn’t mean you can truly afford it, says personal finance author Eric Tyson. Look at your overall financial situation and consider whether or not a cash-out refi will get you closer to your goals.

Whenever you cash out your home’s equity, you are extending the time it will take to pay off your mortgage. Even if you’re getting a lower interest rate than what you’re currently paying, you could still end up paying more interest overall. If you have 10 years left on your mortgage and you replace it with a 30-year mortgage, that’s an extra two decades of mortgage and interest payments.

You should make sure the cash-out refinance fees make sense, Beeston advises. Some loans have higher fees, which can make consolidating smaller amounts of high-interest debt with a cash-back refi a potentially bad move. 

When you refinance a mortgage you’ll pay fees based on the entire loan, not just the cash-back portion. On a $200,000 mortgage refinance, you could easily pay $6,000-$12,000 in closing costs. If you only need a few thousand dollars to consolidate debt or make home repairs, a small personal loan might have a higher interest rate, but still be a better option because the origination fees will be much lower. It’s all about what route gets you the cash you need while paying the smallest amount in interest and other fees.

With most lenders, you can’t do a cash-out refinance for more than 80% of your home’s value. But there are some lenders that allow you to take out more equity, like government-backed VA loans, which offer military veteran homeowners up to 100% of your home’s value in a cash-out refinance. If a cash-out refinance increases your loan to value percentage above 80%, you may be adding a private mortgage insurance (PMI) payment back onto your mortgage. PMI can cost 1%-2% of the loan principal every year, so in this situation a cash-back refinance rarely makes sense.

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