How does a cash-out refinance work?

David  Mully
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David Mully
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A cash-out refinance is a way to both refinance your mortgage and borrow money at the same time. You refinance your mortgage and receive a check at closing. The balance owed on your new mortgage will be higher than your old one by the amount of that check, plus any closing costs rolled into the loan. cash out refinance home

It's sort of like "backing up" your mortgage by taking out some of the money you've paid into it and increasing the mortgage principle owed as a result.

There are no restrictions on how you use the proceeds from a cash-out refinance - you can use it for any purpose you like (though there may be tax consequences - see below). Some of the more common ones are home improvements or repairs, paying off other debts, education costs, starting a business or medical expenses.

Cash-out refinancing is basically a combination of refinancing and a home equity loan. You can borrow the money you need, as with a home equity loan or line of credit (HELOC).

 

Cash-out refinancing and home equity

To qualify for a cash-out refinance, you need to have a certain amount of home equity. That's what you're borrowing against.

Let's say your home is worth $250,000 and you owe $150,000 on your mortgage. That gives you $100,000 in home equity, or 40 percent of the home's value.

You generally want to retain at least 20 percent equity after refinancing (though some lenders will go lower), so that gives you $50,000 available to borrow.

To borrow that amount, you would take out a new mortgage for $200,000 ($150,000 already owed plus $50,000) and receive a $50,000 check at closing. This doesn't take into account your closing costs, which are 3-6 percent of the loan amount and are often rolled into the mortgage.

 

Advantages of cash-out refinancing

    • Refinance mortgage rates tend to be lower than the interest rates on other types of debt, so it's a very cost-effective way to borrow money. If you use the cash to pay off other debts such as credit cards or a home equity loan, you'll be lowering the interest rate you pay on that debt.
    • Mortgage debt can also be repaid over a considerably longer period than other types of debt, up to 30 years, so it can make your payments more manageable if you have a large amount of debt that must be repaid in 5-10 years.
    • If market rates have dropped since you took out your mortgage, a cash-out refinance can let you borrow money and reduce your mortgage rate at the same time.
    • Mortgage interest is generally tax-deductible, so by rolling other debt into your mortgage you can deduct the interest paid on it up to certain limits, assuming that you itemize deductions.

If you use the funds to buy, build or improve a home, you can deduct mortgage interest paid on loan principle up to $1 million for a couple ($500,000 single). But if you use the proceeds from a cash-out refinance for other purposes, such as education expenses or paying off credit cards, the IRS treats it as a home equity loan, and you can only deduct the interest on the first $100,000 borrowed by a couple ($50,000 single).

As explained above, there are numerous advantages for refinancing but you have to keep in mind that it small amounts will not make refinance feasible because of final closing costs on the total loan amount.

Disadvantages of cash-out refinancing

One of the big drawbacks of a cash-out refinance is that you pay closing costs on the entire loan amount. So if you owe $150,000 on your mortgage and use a cash-out refinance to borrow another $50,000, you're paying closing costs of 3-6 percent on the entire $200,000.

For this reason, a cash-out refinance works best if you can also reduce your overall mortgage rate or if you wish to borrow a large sum. For smaller amounts, a home equity loan or line of credit (HELOC) may be a better choice.

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    How Much Money You Can Get from A Cash-Out Refinance.

    A cash-out refinance is a loan option that allows buyers to replace an active home mortgage with a new mortgage that has a value higher than the outstanding mortgage balance. The cash difference between the former mortgage and the new one is then withdrawn and can be used for any other major projects that the homeowner wishes. Cash-out refinances are very good ways to utilize the equity that has been built up over the term of the previous mortgage.  

    The amount of money that can be gotten from a cash-out refinance varies depending on the type of mortgage and your credit score. Most lenders permit homeowners to borrow up to 80 percent of the value of their home. That number could rise to 85 percent for lenders offering mortgages that have been insured by the Federal Housing Administration (FHA). All you have to do is find out the current value of your home and the percentage of your home equity that your lender allows you to borrow. 

    Cash-out refinances are useful for several reasons, but the most notable ones have to do with interest rates. However, they are not always the ideal option for you. According to financial analyst Gregg McBride, "Cash-out refinancing is beneficial if you can reduce the interest rate on your primary mortgage and make good use of the funds you take out."

    Differences Between Cash-Out Refinance and No Cash-Out Refinance

    Normally, refinancing a mortgage will mean that you are replacing an existing mortgage with a new one. Both mortgages will have the same amount, but the new one will have a lower interest rate or be for a shorter period. In some cases, the new mortgage will have an amount that is less than the outstanding balance of the existing loan. Sometimes, the new mortgage will both have lower interest rates and a reduced loan term. This type of refinancing is considered a no cash-out refinance. 

    With a cash-out refinance, you will get the chance to withdraw a percentage of your home equity in one lump sum of cash. Due to the nature of a cash-out refinance, it is usually advised that homeowners put a lot of thought into the way they use the money that is withdrawn. For example, using the cash to get a new degree that can help you earn more income is a wise option, but using it to start a high-risk business isn’t. 

    If what you are looking for is to lower the interest rate of your existing mortgage or change the loan term, then you should go for a refinance without a cash-out. However, if you are looking to tap into the equity of your home and withdraw money to fund major home or personal projects, then a cash-out refinance is ideal.

    Frequently Asked Questions

    Put simply, a cash-out refinance involves taking a mortgage that is bigger than the one you currently have, and withdrawing the cash difference between both.

    The idea of refinancing a loan is simply replacing your current loan with a new loan. The new loan could have a different rate, loan term, or amount.

    It takes 3-5 days after a cash-out refinance before you receive your funds.   

    Lenders allow you to withdraw between 80-85 percent of your home equity.

    Yes, you can pull money out from the equity of your house. If you need funds to carry out major projects such as remodeling your house and paying school fees, you should consider taking a cash-out refinance.

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