What is a Cash-Out Refinance?
If you’re looking to access funds for a home renovation project or to pay off high-interest debt, then look no further than your home! That’s right. Your home is full of accessible “cash” so long as you’ve acquired equity.
Equity represents the portion of your home that you own yourself. In other words, it’s the current market value of your home minus your outstanding mortgage balance. You help it increase as you pay down your balance or make home upgrades, though it can also grow on its own with the real estate market as home prices rise and the economy strengthens.
Now that you understand equity let’s discuss one of the most popular ways to access it — a cash-out refinance.
How does cash-out refinancing work?
Homeowners look to cash-out refinancing to turn some of their home equity into cash. It works by refinancing your mortgage at a higher amount. The new loan pays off your old loan, and that extra money (from refinancing at a higher amount) is distributed as cash. Your equity will lower after taking cash out; however, it can grow again as home prices increase and as you start paying down your new loan.
You will need equity in the home before you can access cash. So, your home needs to be worth more than you owe on your mortgage.
Some homeowners choose this option to manage more expensive forms of debt like credit cards or personal loans. Choosing to consolidate debt allows homeowners to save hundreds (sometimes thousands) while reducing their total debt load. Others prefer to pay for home renovations since many projects cost upwards of $50,000 or even $75,000. Let's not forget that money can also be used toward a down payment on an investment or rental property.
No matter how you choose to use the money, know that you will enjoy relatively low interest rates (compared to credit cards and personal loans) because your home secures the loan.
Calculate your maximum amount of available cash
Let’s consider an example. If you owe $200,000 on your home, but it appraises for $275,000 — you have $75,000 in home equity. Most loan programs will allow you to access up to 80% or in this case $20,000, which can be distributed as cash.
Not sure what your home is worth? Check out websites like Homebot or Redfin to get an idea of your estimated home value. Or, ask your real estate agent to complete a comparative market analysis (CMA) on your property. Though, your best option is to call your mortgage lender. They can find your home value for you and can get you started on the application process.
What credit score will I need to qualify?
The minimum credit score to take cash out of your home equity varies by lender. It typically falls between 600 and 660. Keep in mind; credit scores affect loan rates differently. If your score is on the lower end, expect to be charged a higher interest rate. It shouldn’t come as a surprise that lenders are careful who they lend to, especially when writing a loan that’s higher than the original mortgage.
Not sure of your credit score? Get a free credit report from WalletHub.
If your score comes back less than perfect, don’t stress out too much. There are things you can do to increase it. A perk to working with American Financing: if you’re just shy of meeting loan program qualifications, our in-house credit care team can coach you through credit weaknesses and next steps.
How does loan to value (LTV) apply?
LTV is the ratio of your current mortgage balance compared to the market value of your home, as determined by an appraisal. Mortgage lenders usually allow cash out up to 80% of the property value, but FHA allows 85% and the VA allows 100%.
When refinancing to access cash, your loan may not exceed a maximum loan-to-value ratio. That means your total home debt can't exceed a certain percentage of the value of your home.
To calculate your LTV, follow this formula: Current Loan Balance ÷ Current Appraised Value = LTV.
Popular loan options: government-backed FHA and VA mortgages
FHA loans have relaxed guidelines, meaning borrowers with lower credit scores and higher debt-to-income ratios may have an easier time qualifying (compared to conventional loans).
With a higher LTV of 85%, you’ll be able to get more money out of your refinance with an FHA loan.*
Keep in mind, if your LTV is higher than 80%, you won’t qualify for a conventional loan. On the other hand, you will have to pay a mortgage insurance premium, which increases your monthly payment.
The FHA also limits the loan amount depending on where you live. You can look up the annual loan limit for your area on HUD's website.
Qualified veterans have the opportunity to refinance their VA loan* to a lower rate while taking advantage of cash from their home equity. In the case of a VA loan, the borrower has access to 100% of the current home value (as opposed to 85% like most loan programs allow). However, borrowers are charged a VA funding fee when refinancing. That fee ranges from 2.15-3.3%. It can be avoided if you’ve experienced a service-connected disability.
*VA cash-out loans are not available in Texas because of their state laws regarding home equity loans.
All refinances require closing costs. Closing costs are typically three percent to six percent of the mortgage. Essentially, you can expect to pay most of the same fees you paid when you closed on your first mortgage. In 2018, the national average of closing costs paid was almost $5,800 per transaction (according to data released on Nov. 26, 2019, by US News).
Loan terms don’t have to reset
With some lenders, you have to reset your loan term to 30 years (or your original loan term) after a cash-out refinance. That’s not how we work.
At American Financing, you can choose your loan term thanks to Your Term, Your Mortgage.
It’s an easy way to access to cash while staying on track to being mortgage-free, and it doesn’t matter which loan program you choose: VA, FHA, conventional, etc., we can write the terms so they fit your payoff schedule.
NEW! Tax deduction changes as of 2018
Starting with 2018 tax returns filed in 2019, interest paid on a cash-out refinance or home equity loan is only deductible if used to buy or make “substantial improvements” to your home.
You cannot deduct interest paid if you use the loan to pay off high-interest debt or fund college tuition.
Be sure to consult with your tax advisor if you have questions regarding a cash-out mortgage refinance tax benefits.
Cash-out mortgage vs. HELOC
A home equity line of credit, or HELOC, is a second loan on top of your first one, while a cash-out refinance replaces your existing mortgage.
A HELOC can be useful for some people who want to pull money out over a longer time. That's because a HELOC works as a line of credit instead of a lump sum payment. But note that the interest rate on a HELOC varies, so it will only be locked in for a limited time. Also, the interest paid on HELOCs is no longer tax-deductible. In this case, a cash-out mortgage could be a better option as it can reduce your taxable income and land you a bigger tax refund.
Cash-out refinance to buy a second home
With home prices on the rise, many Americans are using a cash-out refinance to buy a second home or an investment property. Eligibility depends on several factors, including the amount of equity you have in your current home. Know that there are rules and limitations with this, which is why we suggest talking with a mortgage expert to learn more.
How long does a cash-out refinance take?
It can take several months for a borrower to close on a cash-out refinance. Things such as documentation (whether the borrower is a W-2 employee or self-employed), lender capacity, and market trends all factor into the equation. That's why it's important to be both responsive and patient with your lender throughout the loan process.
The bottom line
A cash-out mortgage refinance is a great option if you can get a good interest rate on your new loan and you have plans to spend the money wisely (debt consolidation or home improvement). Learn more about this program, and other refinance options, by making a 10-minute call to one of our mortgage consultants. They'll walk you through the pros and cons of a cash-out refinance, helping you decide whether such a loan makes sense for your situation.
You can also schedule an appointment online.
*FHA, VA, Conventional, and USDA loan requirements are subject to change. Jumbo and non-QM loans may be temporarily unavailable. As a result of COVID-19, mortgage investors are unable to support as many loans, meaning underwriting guidelines for government and conventional loans are becoming more strict.