What is Cash Out Refinancing?

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Point of Interest

Cash-out refinancing can be an excellent option if you need access to extra funds and have a decent amount of equity in your home.

If you own a home, have a fair amount of equity in it and need to borrow additional funds on top of your mortgage, you may want to consider a cash-out refinance. Cash-out refinancing allows you to simultaneously refinance your home and get access to additional funds for things like home improvements, paying down credit card debt, financing education or any other expense. 

Much like a home equity loan, the amount of additional funds you can borrow with a cash out refinance depends on the amount of equity you have in your home.  There are other features that set this type of refinancing apart as well, so while cash-out refinancing can be a handy tool for homeowners in need of cash, it’s important to know what you’re getting into before signing on the dotted line.

What is cash-out refinancing?

What is a cash-out refinance? With cash-out refinancing, your current mortgage is replaced with a new mortgage with a greater amount than you previously owed on your home. The difference between your new mortgage and your current mortgage balance is given to you in cash, which you can then use to cover various expenses.

You’ll need to have equity in your home to qualify for cash-out refinancing. Equity is the difference between the value of your home and the current principal balance of your mortgage. If your home is valued at $200,000 and you owe $150,000, you have $50,000 in home equity.

How does cash-out refinancing work? 

The amount of money available to you through cash-out refinancing depends on both the value of your home and the amount of equity you have. Most lenders will cap the cash-out amount at between 80% and 90% of your equity because they want you to retain some equity in your home. Your interest rate will be a bit higher than traditional financing since your loan amount is larger.

There are a number of situations in which cash-out refinancing may be ideal, including:

  • Interest rates have fallen since you took out your mortgage, and refinancing would significantly lower your interest payments.
  • You have high-interest debt (e.g. credit card) that could be consolidated and paid off.
  • You want to make improvements or repairs to your home that will increase the value.
  • You need help paying your child’s college tuition.
  • You have a large number of medical expenses.

Tip: If you use cash-out refinancing to pay off credit card debt, resist the temptation to use your credit card indiscriminately in the future.

You can use the money from cash-out refinancing in any way you choose, but be aware that there are tax implications. If you spend the money on a home purchase, home improvements or building a home, the funds are treated like a mortgage. Interest payments on the first $1 million of the principal are tax-deductible (or $500,000 if you’re not married). If you spend the money on anything else, it is considered a home equity loan by the IRS, and interest payments are tax-deductible on only the first $100,000 of the principal (or $50,000 if you’re not married).

Examples of cash-out refinancing

Let’s look at what cash-out refinancing might look like in terms of real numbers. 

Example #1: The value of your home is $200,000 and the balance of your mortgage is $150,000, which means you have $50,000 in equity. A lender agrees to give you a new mortgage that includes the balance of your old mortgage ($150,000) plus 80% of your home equity ($40,000), for a total of $190,000. You can use the $40,000 however you choose.

Example #2: The value of your home is $500,000 and the balance of your mortgage is $250,000, meaning you have $250,000 in equity. A lender agrees to give you a new mortgage that includes the balance of your old mortgage ($250,000) plus 80% of your home equity ($200,000), for a total of $450,000. You can use the $200,000 however you choose.

Pros of cash-out refinancing 

  • Lower interest rates — The interest rates on refinance mortgages are often lower than other kinds of debt. Using the additional funds to pay off high-interest debt is an effective way to reduce overall interest payments.
  • Extended repayment time — The repayment period for mortgage debt is significantly longer (15–30 years) than other types of debt, allowing you to spread out your payments.
  • Reduced interest rates — Cash-out refinancing allows you to take advantage of lower mortgage interest rates.
  • Tax deductions — In most cases, mortgage interest is tax-deductible. Consolidating most or all of your debt into a single mortgage payment can increase your tax deductions.

Cons of cash-out financing

  • Closing costs — Refinancing brings closing costs, which are usually between 2% and 5% of the total mortgage amount. 
  • Private mortgage insurance — You will end up paying for private mortgage insurance (PMI) if your new mortgage exceeds 80% of your home’s value.

Cash-out refinancing vs. home equity & HELOC

With a home equity loan, you are getting a second mortgage based on the amount of equity in your home. You receive the total amount in a lump sum and must pay it back like any other mortgage. Home equity loans usually have higher interest rates than cash-out refinance mortgages, making them the less desirable of the two options. 

A home equity line of credit (HELOC) is similar to a credit card in that you have access to a total amount of funds but only pay back what you actually spend. A HELOC offers more flexibility than cash-out refinancing, which is useful if you don’t know precisely how much you need to borrow. The downside is that HELOC interest rates are variable and almost always go up after 12 months.

FAQs

How does a cash-out refinance work?

Cash-out refinancing allows you to borrow against your home equity. Your current mortgage is replaced with a new mortgage that is greater than what you currently owe, and you are given the difference in a lump sum of cash.

Is cash-out refinance a good idea?

Cash-out refinance is a good idea if you need money to cover expenses AND mortgage interest rates are equal to or lower than what you are currently paying. Always do the math to ensure you won’t end up paying significantly more over the long run by refinancing.

Which is better: a cash-out refinance or home equity loan?

Because cash-out refinance interest rates are usually lower than home equity rates, cash-out refinance is usually a better option.

The final word

If you need extra cash and have some equity in your home, you may want to explore cash-out refinancing. This type of refinance offers relatively low interest rates compared to other types of debt, and a cash-out refinance can be an effective way to pay for home renovations, consolidate credit card debt, cover medical costs or pay for any other type of expense. You’ll need to know what you’re getting into before you go through with this type of loan, though — otherwise you may find yourself in way over your head.