Purchasing a home is one of the largest investments you’ll make in your lifetime, and it’s important to protect your investment. For some homeowners, that might mean renovating your home to keep it up-to-date and modern. For others, it might mean protecting the terms of your mortgage.
Refinancing is a common process homeowners go through to replace their existing mortgage with one that has more favorable terms – either a lower monthly payment or a lower interest rate. However, if you’d like to refinance with the goal of cashing out part of the equity in your home, a cash-out refinance is a perfect choice.
WHAT IS A CASH-OUT REFINANCE?
As you pay off your mortgage, you continually gain equity in your home – the amount of your home’s value that you actually own. This generally happens through your monthly mortgage payments paying down the principal, or if the value of your home increases.
A cash-out refinance allows you to use the equity you’ve built up by replacing your existing mortgage with a new home loan for more than you owe. The difference then goes to you in cash.
This is different than a traditional refinance, which replaces your current mortgage with a new mortgage for the same amount. Typically, refinancing is used to lower your monthly mortgage payments or to take advantage of a lower interest rate. A cash-out refinance is used to leverage your equity in exchange for cash.
PROS OF A CASH-OUT REFINANCE
- Flexibility. By using a cash-out refinance, you have the flexibility to use the cash for whatever you’d like. Often, the cash goes toward a home improvement that has the potential to increase the value of the home, but it’s up to you to decide.
- Improve your credit score or pay off credit cards. By using the cash to pay off your high-interest credit cards, you are minimizing your credit utilization – an important factor in determining your credit. Once your lower utilization is reported to one of the three major credit bureaus, you could potentially raise your credit score.
- Debt consolidation. Another use for the cash from your cash-out refinance is to consolidate any debt you may have. Depending on the number of accounts you have open, and the corresponding interest rate on those accounts, it may be beneficial to use the cash to pay them off and consolidate your debt under your new mortgage.
- Lower interest rates. When compared to other options like a home equity line of credit (HELOC), or a home equity loan, some homeowners may qualify for a lower rate. Keep in mind, though, that this depends on your financial background and your unique credit history.
CONS OF A CASH-OUT REFINANCE
- Restrictions. Depending on your specific lender, there may be restrictions on a cash-out refinance. For example, you cannot pull out 100% of your home’s equity – this is typically limited to 80% – 90% of the total. Other requirements may include a minimum credit score or a maximum loan-to-value (LTV) ratio.
- Closing Costs. Similar to closing on your initial mortgage, it’s important not to forget about closing costs. When you choose to do a cash-out refinance, you’ll need to factor these in similar to how you would on any mortgage. Your specific costs may vary, but they usually range from 2% – 5% of the amount being financed.
- Bad Habits. We touched on the importance of paying down your credit card debt earlier, but it’s important to avoid bad habits when you have that spending power again. If you choose to use the cash to pay down your high-interest credit cards, it’s easy to fall back into spending again. Try to avoid putting yourself at risk by keeping your credit utilization low.
- Collateral. Finally, remember you are using your home as collateral for a cash-out refinance. It’s absolutely crucial that you make on-time payments, every time. Failure to do so not only will damage your credit, but put you at risk for foreclosure.
IS A CASH-OUT REFINANCE FOR YOU?
While other options are available, such as a HELOC, a cash-out refinance can be a great choice depending on your unique financial background. The flexibility it provides you can open up the possibility to renovate your home, improve your credit, take a vacation, and more.
It’s important to speak with your lender to understand your terms, the rate you may qualify for, and any other costs associated with using a cash-out refinance.