How does a cash-out refinance work?
The major benefit of owning a home is expanding your wealth and making a solid investment in the future. When times get tough, or when you need a little extra cash, some of the equity you’ve built can be used to secure funds and achieve better financial standing through a cash-out refinance.
What is a cash-out refinance?
If you’ve been making consistent mortgage payments over time, and your home has increased in value, you’ve likely amassed a reasonable amount of equity in your home. While equity can be used to sell the home for a profit, some homeowners might need to leverage that wealth before they sell in an effort to gain capital for another purchase.
Cash-out refinancing offers a mortgage refinancing option that provides you with a lump sum of money in exchange for a larger mortgage. Like other refinancing structures, a well-timed cash-out refinance approach could result in a reduced interest rate, lowering the amount you’ll be required to pay each month. However, taking out too much can leave you with mortgage insurance requirements.
Since borrowers get the difference between the two mortgages in cash, this type of refinancing structure is popular among those in need of immediate funds.
For example, as the COVID-19 pandemic unfolded, more and more homeowners found themselves in immediate need of a financial boost. With a cash-out refinance plan, borrowers who lost their job were able to secure enough money to cover some of their expenses for the foreseeable future.
How does a cash-out refinance work?
In general, refinancing allows you to replace your original purchase agreement with a new, updated contract with more favorable terms. When market average rates fall, homeowners seeking to reduce one of their largest monthly expenses might jump at the opportunity to refinance their mortgage.
While a typical mortgage refinance alters the rate and term of your mortgage, a cash-out refinance increases the actual amount borrowed. This new mortgage pays off the remaining balance of the existing home loan entirely, with monthly payments going to your new lender at the altered rate.
Most refinancing plans result in a lower rate and more favorable terms on your loan, depending on what options are available, but the primary purpose of a cash-out refi is to convert home equity into liquid assets.
Unlike a HELOC loan, which adds a second mortgage and payment to your monthly bills, a cash-out refinance replaces your original mortgage with an entirely new one. Since this new mortgage will be worth more than the original, borrowers should expect a prolonged amortization plan compared to their original loan. The “cash-out” provided by this type of refinancing is typically used by the homeowner to make a large purchase or investment.
Advantages of cash-out refinance
Cash-out refinancing is a popular option among homeowners, thanks to the many unique benefits this type of mortgage restructuring provides:
- Possibly pay less each month
- Consolidate your debts
- Make an investment
Possibly pay less each month
If you signed on to your mortgage while mortgage rates were high, you might be able to secure a lower interest rate through a cash-out refinance. For example, applying for a mortgage in the year 2000 would land you with an average interest rate of 8.05%, according to Freddie Mac. If you were to refinance in mid-2021, the average borrower would be able to a mortgage rate of about 3.06%.
While conventional financing would get the same result, a cash-out refinance provides you with money afterward. If you’re only after a reduction in your monthly mortgage payment and don’t need the extra cash, a regular refinancing approach might suit you better.
Consolidate your debts
The money provided by your cash-out refinancing plan could be used to consolidate your other debts, such as high-interest credit cards. Debt consolidation is typically done by taking out a personal loan, which provides the funds to pay off your existing creditors in one installment. Your debt then transfers to the lender who issued the loan, who works with you to build an amortization schedule.
In a cash-out refinance, the money provided can be used for the same purpose. By combining your various debts under one fixed-rate plan, you’ll be more capable of taking back control of your finances. When paying off your mortgage following the cash-out refinance, you’ll open up more financing opportunities.*
Make an investment
The primary reason someone might opt for a cash-out refinance is to invest the funds in something that will boost their bottom line. As a homeowner, for example, you might seek to increase the value of your home before you move, which often requires expensive renovations. Your newly acquired cash can be put toward this goal, boosting your home’s value and adding to your equity in the process.
Your “cash-out” can also be put toward less tangible investments, such as taking on a new course of study that could lead to a better job. Your existing home equity can additionally be used to start a new business venture. While it is a riskier investment, many entrepreneurs have used cash-out refinancing to get their idea off the ground.
Disadvantages of cash-out refinance
A cash-out refinance might seem like a great way to take advantage of the equity you’ve built in your home, but there are a few drawbacks to be aware of before you apply:
- Possibility of foreclosure
- Paying closing costs
- Private mortgage insurance requirements
Possibility of foreclosure
Just like with your original mortgage, your newly structured loan will come with the risk of foreclosure. When you sign your purchase agreement, your lender places a lien on the property, allowing them to repossess the property and sell it back on the market if payments go unmade.
Before you move forward with a cash-out refinances, be sure you can keep up with the restructured payment plan so you can avoid this disadvantage altogether.
Paying closing costs
Since you'll be agreeing to a new mortgage when you refinance, finalizing that agreement means paying the associated closing costs. While closing costs on conventional mortgages usually come to roughly 6% of the home’s purchase price, the fees for refinancing are a bit lower, usually around 3%-5%.
Any fees associated with the appraisal, credit report or real estate attorneys are settled at this stage of the deal, and officially completes the refinancing process.
Private mortgage insurance requirements
A cash-out refinance might come with the added stipulation that borrowers pay for private mortgage insurance. Most lenders require PMI when more than 80% of the home’s value is borrowed.
On a $300,000 house, for example, if you refinance for more than $240,000, you’ll likely have to pay for PMI. This expense can be as high as 3% of the loan amount each year, so be sure you can cover the cost when laying out your refi plan.
Cash-out refinancing allows you to finally take advantage of all the hard work you’ve done toward gaining equity in your home. By restructuring your mortgage for a higher amount, you’ll open up new investment opportunities, like renovating your home or consolidating high-interest debt.
If you’re seeking a lower interest rate on your mortgage, but don’t necessarily need the extra funds a “cash-out” structure provides, there are plenty more refinancing options to choose from.
*Using funds from a Cash-out Refinance to consolidate debt may result in the debt taking longer to pay off as it will be combined with borrower’s mortgage principle amount and will be paid off over the full loan term. Contact Guaranteed Rate for more information.
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