A cash-out refinance is a loan option in which a borrower replaces their current mortgage with a larger one and takes the difference as cash. People interested in this loan program often want to use the funds for home improvements, college tuition, and paying off high-interest debt. Others may end up putting their cash toward retirement or another property.
Today’s low rates and rising home values make it a great time to explore a cash-out refinance! Whether you’ve lived in your home for a few years or ten years, there’s a good chance you have significant equity. Why not let your home work for you and convert part of that equity into cash?
More borrowers use a cash-out refinance as a strategic and affordable way to achieve their goals faster.
Home equity is rising across the country, which is great news for homeowners. Many borrowers see their properties increase by tens of thousands of dollars in a short timeframe. Such growth provides a strong financial cushion when other costs increase.
Before you move forward with a cash-out refinance, you need to understand the process inside and out. Here’s how this loan option works.
You build your home’s equity as the property increases in value, and you pay money toward your loan principal. So, let’s say your home has a current value of $600,000. Maybe you took out a loan for $500,000 several years ago and stay current with monthly payments. You check your statement and see you have a principal balance of $485,000. To calculate your equity, subtract $500,000 from $600,000 and add the $15,000 you’ve paid off from your original loan. The answer is a whopping $115,000 in equity.
Once you have a good estimate of your equity, reach out to a lender. They’ll help you replace your current mortgage with a new one that has a higher balance. You are refinancing for more than you owe. As a result, the funds you receive pay off your existing loan. Then, the difference between the two loans is distributed as one lump sum of cash.
Those interested in a cash-out refinance must go through a process similar to when they obtained their original loan. Be prepared to provide extensive documentation, including bank statements, recent pay stubs, and tax returns. Even if your work situation remains the same, lenders want to be confident that you can repay a new loan, especially one with a larger amount. A lender will also review your debt-to-income ratio (DTI) and credit score, among other factors.
Though a cash-out refinance and home equity line of credit (HELOC) involve equity, they’re different loan programs. A HELOC lets you borrow against your equity every month, whereas you access these funds as a one-time payout with a cash-out refinance. In this sense, a HELOC can be riskier depending on your spending habits from month to month.
Many financial experts compare a HELOC to a credit card. You’re approved to use a certain amount of funds every month, and as you pay off what you use, the more funds you have available. Like what a cash-out refinance entails, you can use these funds however you like, including home improvements and other large expenses.
The key to note with a HELOC is that you must repay your outstanding balance at the end of the draw period. Whether that timeframe is one year or several years, you need to account for the funds you use and your ability to repay that amount. The last thing you want is to use most of your HELOC funds near the end of the draw period.
Repayment terms for a HELOC depend on the lender. Consider talking to several different institutions before making a decision. Borrowers who struggle to stay on top of their HELOC payments risk foreclosure.
So, how do you obtain a HELOC? You must have a certain amount of equity in your home to qualify for this particular loan. With that in mind, you probably won’t be approved for a HELOC if you just moved into a new home.
The amount of funds you can borrow with a HELOC depends on your income, DTI, and other factors. Lenders require you to maintain a certain percentage of equity, as is also the case with a cash-out refinance. There’s a chance you could access as much as 85% of your equity with a home equity line of credit.
When choosing between a HELOC and cash-out refinance, borrowers often decide based on the difference in interest rate. Since HELOCs come with an adjustable rate, your rate could increase down the road. Meanwhile, the fixed rate you’ll receive with a cash-out refinance ensures stability even when the market changes.
Navigating the various home equity loan options can be challenging without the right lender by your side. Make it a point to talk to a salary-based mortgage consultant before getting too far into the process. Everyone’s financial goals are different, and the loan program you choose should help you achieve your specific goals.
A cash-out refinance can impact your life for years to come. The more you know what the loan program involves, the easier your decision will be. Check out these most commonly asked questions regarding a cash-out refinance.
It varies by borrower and the amount of equity they have. Most lenders require you to keep 20% equity in your home with this loan program. The percentage is known as your loan-to-value ratio or LTV.
The follow-up question is, how much money should you get from a cash-out refinance? Say, for example, you qualify to receive $50,000 in cash. You need to determine whether all those funds will be put to good use and if it’s worth the higher loan amount.
You might assume the cash you receive in this transaction is free money. But remember, you’re paying off these funds as a loan every month. Uncle Sam won’t deem this money as taxable income unless you use it a certain way.
Here’s what we mean. Maybe your neighbor has lived in their home for several years and wants to tap into the thousands of dollars they’ve gained in equity. They decide to apply for a cash-out refinance and attain $30,000 during the process.
Your neighbor has countless options in this scenario. They could use the funds to finish their basement, remodel their kitchen, or build a deck. On the other hand, perhaps they want to upgrade their yard.
Making any of these improvements with the funds from their cash-out refinance allows your neighbor to claim the mortgage interest deduction. As they’re often called by finance and tax professionals, capital improvements are permanent additions that add value to your residence. Note that repairs such as a new water heater or air conditioner do not count as a capital improvement.
Alternatively, what if your neighbor wants to use the money from their cash-out refinance for other goals, like paying off credit cards or paying for their child’s college tuition? While this could significantly improve their financial situation, they would be ineligible for the mortgage interest deduction.*
*American Financing does not offer tax advice. Please consult a professional for more information regarding tax implications with a cash-out refinance.
Most cash-out refinance borrowers close between 45 and 60 days. The timeframe depends on several factors, including the lender, market conditions, and the borrower’s ability to provide documentation when requested. Those hoping to close as quickly as possible should do everything they can to prepare these forms before contacting a lender.
At American Financing, our salary-based mortgage consultants pride themselves on ensuring fast closings. Some borrowers are now closing in as fast as ten days!
Some homeowners are reluctant to move forward with a cash-out refinance because they’re worried about a possible change to their credit score. What they may not realize is that any impact will likely be minor. Applying for most loans, including a cash-out refinance, will lead to a hard inquiry on your credit report.
Don’t be too concerned, though, as your score will only experience a minor, temporary drop. It may be worth taking the time to boost your credit score before applying for a cash-out refinance. Things like paying down high-interest debt, staying current with your bills, and disputing any errors on your credit report can help you land a lower interest rate.
The minimum credit score to take cash out of your home equity varies, depending on the lender. While you should qualify for a cash-out refinance with a score between 620 and 660, some lenders have requirements closer to 700. Borrowers should expect to be charged a higher interest rate if their score is on the lower end.
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