In a cash-out refinance mortgage, you take a loan against your home in excess of what you owe, leaving you with cash available to spend. Adding to the debt against your home could be a smart move if the cash is used for the right purpose.
Using it for the wrong purpose, however, could lead to financial distress. “I’ve seen borrowers use the cash-out option, spend the money quickly and end up in a worse situation because of it,” says Bruce McClary, National Foundation for Credit Counseling vice president of communications and U.S. News contributor.
How Does a Cash-Out Refinance Loan Work?
Like other mortgages, a cash-out refinance is a loan secured by a piece of real estate, and is subject to various requirements and limitations. The major factors considered in a cash-out refinance mortgage application are:
Loan-to-value ratio. The 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. You will need equity in the home before you can take cash out.
Debt-to-income ratio. You must show the lender, usually via tax returns, a schedule of debts and pay stubs, that you can afford to make the monthly payments.
Credit score. All borrowers named on the loan must have a credit score that meets the minimum for the loan program and lender.
Underwriting guidelines depend both on the loan program and the lender. For loans that are insured by the federal government, including those via the Federal Housing Administration and Department of Veterans Affairs, credit score, debt-to-income ratio and other limits are set by the insuring agency. Individual lenders may impose stricter limits on government-backed loans. For example, although the FHA loan program requires a minimum credit score of 580 (500 with a minimum 10 percent down payment), an FHA lender may require a minimum credit score of 620.
[Read: The Best FHA Loans of 2018.]
Cash-Out Refinance Loan Costs
A cash-out refinance loan incurs costs similar to those for your original mortgage. Certain fees are standard, and others are common but may vary. Cash-out refinance costs may include:
— Origination fee: This is the fee the lender charges for making the loan.
— Title search: It is performed to ensure the person claiming title to the property is the rightful owner.
— Title insurance: The policy offers protection to the lender and owner from claims against the property.
— Appraisal: An appraiser determines the market value of the property.
— Discount points: Fees can be paid upfront in exchange for a lower interest rate on the loan.
— Application fee: You pay this fee to apply for the cash-out refinance loan.
— Credit report fee: The lender charges this to pull your credit report.
— Document fees: These pay for preparing, notarizing and recording loan documents.
Borrowers can pay closing costs out of pocket or add them to the loan balance. In a no-cost refinance loan, the lender pays the fees — but you likely pay a higher interest rate.
Here’s what a cash-out refinance might look like when you crunch the numbers:
|Current loan||Cash-out refinance|
|Fees and Points||*||$5,000|
|Current Loan Balance||$196,100||$250,000|
|Interest Rate (Fixed)||3.125||4.125|
|Loan Start Date||9/1/2010||9/1/2018|
|Loan Payoff Date||8/1/2040||8/1/2048|
|Life of Debt||30 years||38 years|
|*For this simplified example, these details are irrelevant.|
|**The cash-out refinance lifetime interest includes eight years of interest changes paid on the original loan.|
Benefits of Cash-Out Refinance Loans
A clear benefit of a cash-out refinance loan is, well, you get cash.
If you use the cash to pay off higher-interest debt, you’re likely to see an improvement in your credit score as soon as revolving debts are paid off or paid down. You may save money on interest charges or relieve stress on your budget by lowering your total monthly debt payment.
Why You Might Want to Take a Cash-Out Refinance Loan
Nathalie Martin, associate dean for faculty development at the University of New Mexico School of Law, consumer law researcher and consumer credit advocate, says the best reason to refinance is to save money, such as by lowering the interest rate, and the best reason to turn equity into cash is to do necessary maintenance or make quality-of-life home improvements to the home. “If you can still afford the loan, a remodel is probably a good use for the cash, because you’re adding value to the home,” she says.
McClary says that furthering your own education can also be a good use of the cash. “If you use the money to put yourself through a professional training program that improves your marketability and leads to jobs with higher income potential, that could be a good investment,” he says.
Another reason to refinance and access the cash in your home is paying off higher-interest debt.
[Read: The Best Mortgage Refinance Lenders.]
When a Cash-Out Refinance Might Not Make Sense
When you take a cash-out refinance, you’re reducing the percentage of your home that you own and increasing the amount you owe. You may also lengthen the life of your loan, and if you refinance to a higher interest rate, you will increase the cost of your prior home debt. Weighing the pros and cons may be complex. Consider these examples.
You want to pay off credit card debt. Financial experts are split when it comes to using a cash-out refinance mortgage to pay off high-interest credit card debt. On the one hand, paying off a 17 percent annual percentage rate debt with a 5 percent APR loan could save you a significant amount of money. You may not save money overall, though, if you finance this debt for 30 years.
The biggest risk with using a cash-out refinance for debt consolidation is the potential to run up the debt again.
“Paying off high-interest credit card debt seems like a good idea,” says McClary, “but not if you run the debt back up on those cards after you pay them off.” In his former role of credit counselor, he worked with borrowers who did just that. “They ended up doubling the original debt and couldn’t bail themselves out a second time.”
Another risk associated with paying off credit card debt is in changing it from unsecured to secured debt. “I don’t like cash-out refis for debt consolidation,” says Martin. “If you get really far behind and file for bankruptcy, credit card debt can be discharged.” A credit card company can sue you for payment, but it can’t take your home away if you don’t pay. When you use a mortgage to pay off credit card debt, the new debt is secured by your home. If you run into financial trouble and can’t pay your mortgage, you face foreclosure.
You are well into your existing mortgage. If you’re 20 years into a 30-year loan and you take a new 30-year loan, you will make 50 years of payments on your home. However, you can mitigate this drawback by refinancing into a shorter loan term such as 10 or 15 years.
When a Cash-Out Refinance Doesn’t Make Sense
Don’t take cash out of your home to pay for something that you don’t need and can’t afford, or if it doesn’t fit well into a responsible financial plan.
You want to take a vacation. “Don’t use a home loan to go on vacation,” says Martin. “It sounds flippant, but this is something you need to save up for.” Loans incur costs, and it doesn’t make sense to set yourself up for years of payments — and interest charges — for a nonessential expense.
You want to buy a car. A cash-out refinance may not be a good idea when you need a car. Most mortgages last for 10, 20 or 30 years, so you could be paying for the car long after it has lost its value and usefulness. Car loans, on the other hand, typically last for three to seven years.
Someone needs your financial help. Don’t borrow against your home to help a friend or family member out of a financial jam. “That rarely works out,” says McClary.
The interest rate is significantly higher. If the interest rate on your new mortgage will be a lot higher than the rate on your existing mortgage, research other kinds of financing.
You’re close to retirement. If you expect to stop working before your refinanced mortgage will be paid off, the payment could strain your monthly budget.
[Read: The Best Home Equity Loans.]
Alternatives to Cash-Out Refinancing
A home equity loan or home equity line of credit may be a good alternative to a cash-out refinance loan. A home equity loan is a lump-sum loan borrowed against the equity in your home, usually at a fixed interest rate. A home equity line of credit allows you to draw funds against the equity in your home multiple times, up to a maximum amount, usually at a variable interest rate. Both of these products are additions to, not replacements for, your existing primary mortgage.
The interest on a home equity loan or home equity line of credit is tax-deductible (up to a loan of $750,000, or about half that for a married taxpayer filing separately) if the funds are used to “buy, build or substantially improve the taxpayer’s home that secures the loan,” the IRS says.
Some expenses can be covered with other types of loans that may make better financial sense. For example, you might qualify for a car loan with a competitive interest rate. For education expenses, federal student loans offer the most flexibility in repayment options and loan forgiveness. Even private student loans may be preferable to a loan secured by your home.
If you have debt to pay, you can devise a plan to pay it off the old-fashioned way or talk to a credit counselor who can help you create a new budget. You can also consider entering into a debt management plan or applying for a debt consolidation loan.
For a vacation or other luxury expense, the best financial plan is to save up for the purchase.
What to Do Before You Get a Cash-Out Refinance Mortgage
Work to improve your credit before you apply. There are gaps between good credit offers and fair credit offers. “That’s a good incentive to improve your credit before you apply, because you could save tens of thousands of dollars over the life of the loan,” says Martin.
Here’s an example of how much borrowers with different credit scores might pay for the same loan:
|$200,000 30-year Fixed-Rate Loan|
|Credit Score||Interest Rate||Monthly Payment||Total of Payments After 30 Years|
Make a clear plan for how you’ll use and repay the cash before you apply for the loan. Calculate and consider your new monthly payment, including taxes, insurance and any homeowners association fees. It’s especially important to be comfortable with the new payment if it will be higher.
Compare at least two loan offers to get an idea of the range of fees and costs. Loan shopping can be easy in today’s marketing environment. “As soon as you start shopping for a mortgage, other lenders will pick that up, and you’ll start receiving solicitations,” says Martin. “Take a look at those offers, and pin them down on closing costs.”
McClary agrees, saying, “I’ve seen people with terrific credit scores and qualifying income take a well-advertised subprime loan without shopping around when they could have gotten a much better deal.”
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