What is a cash-out refinance?
When you refinance your home, you replace your existing mortgage with a new one. Usually, the goal is to replace the loan with a mortgage that offers better refinance interest rates and loan terms. This can save you money over the life of your mortgage loan.
It is similar to a rate-and-term refinance, which benefits homeowners by allowing them to capitalize on more favorable terms. However, a cash-out refinance allows you to convert a portion of your existing equity into available cash.
The cash-out refinance process
With this financing option, you’ll replace your existing home loan with a larger one.
The difference between the two will be the amount of money you can tap into when you “cash out.”
Most lenders require you to maintain at least 20% equity in your home after a cash-out refinance.
For example, imagine you own a home valued at $350,000, and your remaining mortgage balance is $50,000. That would mean you have $300,000 in equity. Your lender will expect you to keep at least 20% of that $350,000 valued home, which would be $70,000.
In this example, you can receive financing for as much as $230,000 ($300,000 – $70,000).
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Not all lenders will require you to maintain 20% equity in your home, so it’s wise to understand the requirements.
This is especially important as it applies to additional fees associated with the process. These fees can include closing costs, administrative fees, and appraisal costs.
Lenders will also evaluate you, looking at things like your credit score and debt-to-income ratio.
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One of the most important considerations is determining the amount of cash you need. For example, are you using the money for home improvements? If so, you’ll want to get estimates from renovation contractors in advance so you can pinpoint exactly how much to claim.
If you’re unsure of your needs or want greater flexibility, consider a home equity line of credit (HELOC) as an alternative.
This financing option offers a revolving credit line that can be ideal for flexible projects, though it will add a second mortgage to your loan rather than replace it entirely. A cash-out refinance may be better if your financial needs are more concrete.
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Once you’ve decided that a cash-out refinance is the right choice for your situation you can start applying. That will mean having your documentation together, including your bank statements, pay stubs, and contractor estimates, to verify your financial need.
As you move through the application process, your lender may ask for additional information. Be prepared to provide other documents as needed.
Reasons for a cash-out refinance
Like personal loans, cash-out refinancing can be used for various purposes. For instance, a cash-out can allow you to:
- Complete home improvement projects
- Consolidate debt
- Cover unexpected repairs and expenses
- Invest your extra cash
While many homeowners choose a cash-out refinance to perform home repairs or remodeling, you have considerable flexibility in allocating the cash you receive. What’s more, you still obtain the potential benefits of a refinance, especially if your credit history has improved since you first secured your mortgage.
A cash-out refinance can allow you to tap into your equity and potentially secure better mortgage rates.
Pros and cons of cash-out refinancing
Is cash-out refinancing right for you? The answer depends on your current financial situation, as well as your broader financial goals.
Pros
Cash-out refinancing can have many advantages. For example, it allows you to do all of the following:
- Potentially obtain lower interest rates than personal loans or other financing options
- Improve your credit score by using loans to pay off existing debt
- Fund home improvement projects or big purchases
- Use the funds for other flexible reasons
Cons
The above-mentioned benefits certainly make cash-out refinancing an attractive option. But before you commit to the process, you should be aware of the drawbacks. For example:
- Your interest rate may go up
- Some lenders charge private mortgage insurance (PMI)
- Your new loan may extend your loan period, locking you into long-term debt
- Tapping into your home’s equity won’t improve your financial discipline
- The process comes with appraisal fees, closing costs, and other expenses
Furthermore, your monthly mortgage payments will likely increase if you take out a large loan amount. If you can’t make these new, higher payments, you risk foreclosure on your home.
FHA cash-out refinance
An FHA cash-out refinance works the same as a normal cash-out plan. The difference is that your new loan will be backed by the Federal Housing Administration (FHA). The primary advantage of this financing option is that it allows you to refinance your home even if you have a low credit score.
The FHA offers multiple refinancing options that make it easy to tap into your home’s equity.
Eligibility
How does an FHA cash-out refinance work? FHA loans are generally easier to obtain than other loan types. As long as your credit score is 500 or above, you can qualify for an FHA loan, though private lenders may have additional guidelines.
Guidelines
FHA cash-out refinancing comes with additional loan guidelines that are unique to the program.
For starters, you can’t owe more than 80% of your home’s value. If your home is worth $200,000, you must have paid more than $40,000 toward your existing mortgage, leaving you less than 80% of the original loan amount.
You must also have lived in your home for at least 12 months before applying for an FHA cash-out refinance, which is a longer requirement than other refinancing options. And if you have any late payments during those 12 months, you automatically become ineligible for the program.
Explore your options
As you can see, cash-out refinancing isn’t right for everyone. But if you have equity in your home and strong credit, this financing option can be a great way to tap into large, flexible sums of cash. For many homeowners, cash-out refinancing can provide the funding for major life needs. These include renovation projects, paying off debt, and financing major costs like a wedding or college tuition.
