Owning a home could be a daunting mission, and it doesn’t stop when you sign the contract. While you might think saving up for the 20% down payment is the most challenging part of owning, consider this: after a few years of living in your home, you’ll probably start thinking about projects to take on and new features to add. After all, who doesn’t want their home to be as beautiful and cozy as possible? But all of that requires cash.
Raising capital to finance repairs and renovations can be challenging for the average American. If you are thinking about remodeling your home or upgrading your HVAC system, a cash-out refinance may be your saving grace.
In this article, we’ll guide you on the ins and outs of cash-out refinance and answer these questions
- What is a cash-out refinance?
- How does a cash-out refinance work?
- How to get a cash-out refinance?
- How much do I get from a cash-out refinance?
- Who should consider a cash-out refinance?
- Is now a good time to refinance?
What Is a Cash-Out Refinance?
A cash-out refinance is a type of mortgage refinance that allows you to take on a bigger loan than what you owe and receive additional cash. By tapping some of the equity you already built up in your home, you can borrow more than you owe and take out the difference in cash. For instance, if your home is worth $500,000 and you currently owe $300,000, you could refinance by taking on a loan of $400,000 and receive $100,000 in cash.
The cash you receive by refinancing your existing loan could be very helpful. You can do just about whatever you want with the funds. You can choose to pay off any credit card debts or take on major home improvements. In essence, a cash-out refinance allows you to take advantage of your home equity to cover any cash needs you might have.
Now, you may be wondering what we mean by “equity.” When you submit your mortgage payment each month, part of the payment goes toward paying off the principal balance of the loan, and by doing so, the portion of the home you own, namely, the home equity, grows over time. Equity is simply the amount of mortgage you have paid off. As a homeowner, you can build equity in three ways:
- Your home value appreciates.
- You pay down your mortgage principal by regular payment of the required monthly mortgage payments. Every time you make payments towards your monthly mortgage payment, you gain equity in the home.
- Make extra monthly mortgage payments as often as possible.
How does a cash-out refinance work?
Let’s look at an example.
Jenny bought a condo for $300,000 and, after several years, still owes $100,000. If the property value has not appreciated or depreciated below the $300,000 mark, she has built up at least $200,000 in home equity.
Let’s say Jenny wants to carry out kitchen renovations worth $80,000. Ordinarily, she would have to opt for a second mortgage or save up a portion of her income to fund the upgrades. But thanks to the built-up $200,000 home equity, Jenny now has the option to work with a lender and take out a new loan for 80% of the home value.
So, for a $300,000 home, this should be around $240,000. Of course, Jenny will need first to pay off the existing loan of $100,000. This leaves her with a great chance of receiving $140,000 in cash to fund her $80,000 renovations and other personal needs.
Now, if Jenny decides only to receive cash of $80,000 for the necessary renovation needs, she could choose to refinance with a $180,000 new home loan. Jenny could receive a better interest rate and more favorable terms with smaller loan size.
How to get a cash-out refinance?
The requirements for qualifying for a cash-out refinance vary by lenders. Below are some of the most common requirements for your reference.
1. Your credit score should be at least 620
Just like applying for a regular mortgage, your credit score should be at least 620, and of course, the higher your credit, the better the rate you’ll get.
2. Your debt to income ratio (DTI) should be 36% or lower.
While some conventional lenders have a maximum DTI requirement of 45%, most would want your DTI below 36%.
Once you’ve met the requirements, you can then calculate the equity you’ve built up in your home.
3. Your equity should be at least 20% of your home value.
Generally, you should have at least 20% in your home to be eligible for a cash-out refinance. In other words, if you only put down 10% when taking out the existing loan, make sure you’ve made enough payments to reach the 20% requirement to increase your chances of getting approved.
4. Calculate how much cash you need
While you can take out 80% to 90% of your home’s market value, keep in mind that the larger the loan, the higher the monthly payments. If you only need $100,000, don’t take out $200,000, as that could be hundreds of dollars more per month.
Once you’ve met all the requirements and have a general idea of how much cash you need, you can then apply for a cash-out refinance loan through your lender. Your lender will likely ask for supporting documents such as proof of income and tax filings. They will also run a credit report on you. If everything goes well and you’re approved, you should receive the money three to seven days after closing. If you refinance through your existing lender, they will handle the mortgage payoff for you. But if not, make sure you pay off the loan with the proceeds.
How much cash can you get from a cash-out refinance?
In general, lenders will let you receive up to 80% of your home equity. The LTV requirement varies significantly from lender to lender and may depend on your current financial situation. FHA lenders may allow you to draw up to 85% of your home value, while VA allows up to 100% of your existing equity if you meet specific requirements.
The amount of money you can receive from a cash-out refinance depends on your home equity, lender, credit score, and existing loan program. Before approaching a lender for a cash-out refinance, you’ll need to have your home appraised to find out its current market value.
Remember to also factor in the closing costs. When doing a cash-out refi, expect to pay around 3% to 5% of the total new loan amount for closing costs. Your closing costs will cover the lender’s origination and appraisal fees. Keep in mind that you might not receive the cash right after closing. Most likely, you’ll receive your money three to seven days after closing.
Who should consider a cash-out refinance?
While cash-out refinancing does come with many financial benefits, it has its share of demerits. Below are some of the fors and againsts for cash-out refinancing.
Some of the positives include:
1. You can take on major home improvement projects
If you are looking to repair a broken roof, upgrade the kitchen, or even build a swimming pool, then a cash-out refi can be of great help. Remember that a cash-out refinance might be eligible for mortgage interest tax deduction if you use the received cash to improve your property.
2. You can consolidate your debt.
A cash-out refinance can provide you with the money needed to pay down your debt and transfer your multiple debts into a single debt with lower interest payments. Make sure, however, to compare the interest rates between debts to ensure you are getting the best option.
3. You can diversify your investments.
Cash-out refinancing can help you access the necessary capital to diversify your investment portfolio or build your retirement savings.
Some of the downsides are:
4. Your rate may go up.
With a larger loan, your rate could potentially go up, as the lender will have to take on more significant risks. If your rate increases by a large percentage, a cash-out refinance might not be your best option.
5. You are at a greater risk of losing your home.
While taking out additional cash might sound appealing to most homeowners, remember that you will still have to pay it back. Don’t take out a loan you can’t afford just because it’s nice to have the cash. Your monthly payments will likely go up once you refinance with a bigger loan. So, you’d want to make sure that you can cover the repayments before making a move.
6. You might need to pay private mortgage insurance (PMI)
You won’t have to worry about this if you stick to the 80% LTV threshold. However, if you need a lot of cash and your lender allows up to 90% or even 95% of LTV, make sure you factor in the additional PMI payments. Your PMI could be as high as 2% of your home loan and could make your cash-out refinance a lot more expensive.
Is now a good time to refinance?
If refinancing is part of your long-term plans, now is a good time to do it. Below are two major reasons you should refinance your mortgage sooner than later.
The interest rates are still low.
While today’s refinance interest rates aren’t as low as they used to be during the peak of the pandemic, all mortgage rates are still at historic lows. But they might not stay low in 2022. The Fed recently signaled that it would soon speed up the bond tapering to keep inflation in check. This means that the rates will likely go up starting 2022. As a smart homeowner, you should take advantage of the low rates and lock in a rate.
The housing market is hotter than ever.
2021 has been an incredible year for real estate. Home prices skyrocketed in major cities like Austin, TX, Boise, ID, and Raleigh, NC. For homeowners looking to refinance their homes in these markets, their homes are likely valued higher. A higher market value means a larger difference between the value and the home equity, and therefore more cash to take out when you refinance.
Elijah O. Agor, CFP
Elijah O. Agor is a real estate, 1031 exchange, and mortgage writer. He is a certified financial planner, former loan originator, and chief realtor for Dsquared Realty. In the past, Elijah advised first-time and seasoned home buyers on real estate and mortgage decisions in the Greater Atlanta area. Since hanging up (burning) his suits and ties, Elijah now works to make mortgage and real estate topics understandable and jargon-free.