Is a Cash-Out Refinance a Smart Move?

Is a Cash-Out Refinance a Smart Move?

If you've been paying your mortgage for a while or your home has increased in value, a cash-out mortgage refinance allows you to access some of the equity in your home. A cash-out refinance allows you to get a new mortgage for more than you currently owe and keep the difference as cash.

If you have a good reason to tap the value of your home, such as paying for college or home renovations, a cash-out refinance may be a good idea. A cash-out refinance works best when you can also get a lower interest rate on your new mortgage than you do on your current one. That may be difficult in today's rising-rate environment. So, when does it happen?

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What Exactly Is a Cash-Out Refinance?

A cash-out refinance occurs when you take out a new mortgage to repay your existing mortgage that is larger than the existing mortgage. The difference is paid in cash to you.

Cash-out refinances allow homeowners to use their home equity to cover expenses such as medical bills, home improvements, debt consolidation, and other large purchases.

According to Freddie Mac, 42% of all refinances in 2021 were cash-outs, owing to the low interest rates at the time, which made refinancing a great deal. However, average rates are expected to exceed 6% for the first time since 2008 on September 15, 2022.

Even though interest rates are higher, homeowners are still building equity in their homes. According to CoreLogic, mortgaged homes' equity increased by 27.8% in the second quarter of 2022 compared to the previous year. That's a $60,200 increase per borrower in one year. Cash-out refinancing may still be worthwhile for some people with more equity to work with.

Whatever the economic climate, understanding the advantages and disadvantages of cash-out refinances and crunching your personal numbers is critical before proceeding.

What is a Cash-Out Refinance?

A cash-out refinance works similarly to a regular refinance, except that the amount of equity in your home is more important. Lenders will typically approve a cash-out refinance up to 80% of your home's appraised value. This is referred to as the loan-to-value ratio. (A higher LTV is usually possible with a regular refinance.)

Sean Grzebin, Chase Home Lending's head of consumer originations, provides the following example: Assume your home is worth $200,000 and you owe $100,000 on your mortgage. That means you have $100,000 in equity in your home. Your new loan can be up to $160,000 with a maximum LTV of 80%. Paying off your current mortgage would leave you with approximately $60,000 in cash (less any fees or closing costs if you roll those into the loan).

Requirements for Cash-Out Refinance

Getting approved for a cash-out refinance is similar to getting approved for a regular refinance, but some lenders may hold you to higher standards, according to Grzebin. "To ensure a customer's ability to repay the loan with higher monthly mortgage payments, cash-out refinances typically require a higher credit score and lower loan-to-value ratio," he says.

In general, refinance lenders prefer borrowers with a minimum credit score of 620, a debt-to-income ratio of 43% at most, and consistent employment income.

You may be required to provide a "cash-out letter" in addition to meeting the lender's debt-to-income ratio, credit score, and income standards, according to Nicole Rueth, senior vice president for The Rueth Team at OneTrust Home Loans. "It is an additional document required for the loan that simply states your intent to use the funds. It could be as simple as debt consolidation or home remodelling "Rueth says

Another factor to consider is that a cash-out refinance usually does not include an appraisal waiver, according to Rueth.

How Much Money Can a Cash-Out Refinance Get You?

With a cash-out refinance, the key number to remember is an 80% loan-to-value ratio, as that is the loan limit set by Fannie Mae and Freddie Mac. In other words, you can borrow up to 80% of the appraised value of your home. The more equity you have to begin with, the more cash you can withdraw.

Some lenders also impose limits on the amount of cash you can receive, even if your LTV is less than 80%. As you compare lenders, make sure to ask questions.

The Benefits and Drawbacks of a Cash-Out Refinance Pros

Rates are lower. If interest rates are lower than what you are currently paying, or if your financial situation has improved to the point where you can qualify for better rates and terms, a cash-out refinance may be advantageous, according to Grzebin.

Lower your monthly expenses. If you use a cash-out refinance to consolidate your debts, you may be able to reduce your overall monthly expenses and relieve some financial stress. This is especially true if you have a lot of consumer debt with high interest rates.

More money on hand. If a cash infusion would assist you in meeting a personal financial goal, such as a home renovation or paying a medical bill, a cash-out refinance can provide the funds you require. Funds from a cash-out refinance can also be used to buy out another person's share of a property, making it a popular tool for divorced couples.

Cons

There is too much debt. If your life circumstances change after a cash-out refinance, you may end up putting your home at risk if you are unable to repay the new loan.

Increased pay. If you are unable to obtain a lower interest rate, a cash-out refinance may result in higher payments than your previous mortgage. According to Grzebin, "cash-out refinances may also necessitate a slightly higher interest rate than standard refinances."

Inverting the situation. If the value of your home falls, a cash-out refinance may result in you owing more than the home is worth. However, with today's 80% LTV requirement, Rueth claims that risk is lower than it was before the 2008 mortgage crisis, when lenders permitted more aggressive borrowing.

Alternatives to Cash-Out Refinance

If you need money but don't want to take out a cash-out refinance, you do have other options for tapping into your home equity.

Home Equity Line Of  Credit

A HELOC is a separate loan that creates a second lien on the property. However, it is not a loan; rather, it is a line of credit from which you can draw as needed. Closing costs are low. For the first five or ten years (depending on the terms), you only have to pay interest or a small minimum payment on the amount borrowed. After that time, you must start repaying the principal plus interest.

The interest rate is variable and linked to the prime rate, which is a disadvantage. "As the Fed rate rises, which is expected to exceed 4%, so will the cost of home equity lines of credit. Probably to 6%, with a chance of reaching 7% "Rueth says "As the mortgage payment fluctuates, the higher interest rate on that variable line could be painful."

Home Equity  Loan

A second mortgage is another term for a home equity loan. You take out a second loan against your home equity, which means you'll have an extra payment to make every month. A home equity loan has the advantage of having a fixed interest rate. The key to making this product work for you is to not borrow more than you can afford to repay.

Refinance with Cash Out Home Equity Line of Credit Only one loan payment Two loans to repay Two loans to repay Typically, fixed rates Variable interest rate Fixed interest rate One-time payment Credit line to be used as needed One-time payment Simpler to manage More freedom in terms of borrowing amount Cost predictability Increased closing costs Closing costs are reduced or eliminated. Closing costs are reduced or eliminated. Is a Cash-Out Refinance a Smart Move?

"A cash-out refinance can be profitable, even in a rising-interest-rate market," says Rueth, "when the long-term circumstances suggest success."