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What is a cash-out refinance?
Cash-out refinance is the process of borrowing a loan amount larger than your existing outstanding balance when you refinance your mortgage. Refinancing allows homeowners to pay off their existing mortgage with a new home loan that has better terms like a lower mortgage rate. When you refinance with a cash-out option, you are borrowing funds greater than what is required to pay off the current mortgage, allowing you to keep the difference in cash. These funds can be used for debt consolidation, remodeling, renovations, or other financial needs.
It is important to realize that you are not taking a separate loan for a cash-out or have to make separate payments, instead, when you use a cash-out option, your outstanding balance on your refinanced mortgage increases.
How does a cash-out refinance work?
In order to understand how a cash-out refinance works, it is crucial to see how a refinance without a cash-out option works. If you refinance without any cash-out, you borrow funds equal to the outstanding balance of your existing mortgage, and the new mortgage essentially replaces the older one. For example, if your home value is $450,000 and the existing outstanding balance is $300,000, if you refinance without a cash-out, you will borrow $300,000 which will only be used to pay off the existing balance.
In a cash-out refinance, you borrow an amount larger than your existing outstanding balance and keep the difference. The amount of additional funds you can borrow is based on the equity you own in the home. For example, if your home value is $450,000 and the existing outstanding balance is $300,000, that means you have $150,000 in home equity. You can choose to refinance for up to $360,000 where the $300,000 is used to pay off the existing mortgage and the additional $60,000 can be borrowed as a lump-sum amount.
How much can I borrow in a cash-out refinance?
The total amount that can be borrowed as part of a cash-out refinance depends on the amount of equity you own in the home. You can borrow up to 80% of the home value after the outstanding balance has been deducted. This means a maximum loan-to-value (LTV) ratio of 80% can be borrowed, where home equity is the remaining 20%. For example:
In this example, the LTV ratio is 71%. As most lenders allow homeowners to borrow up to 80%, or $280,000 in this case, the total amount that can be borrowed is $30,000 ($280,000 - $250,000). Different mortgage programs have different LTV ratio thresholds. Conventional and FHA loans both have an 80% maximum LTV ratio, whereas VA loans allow up to 100% if you have a credit score greater than 680. You can check the total cash-out refinance amount you are eligible for using our cash-out refinance calculator.
Requirements for a cash-out refinance
In order to get a cash-out refinance, you must meet the basic requirements for a regular refinance.
- Credit Score: Lenders will want a credit score higher than 620 for the majority of conventional loan programs. Government-backed programs like FHA loans require a minimum credit score of 580. VA loans and USDA loans do not have a minimum credit score requirement.
- Debt-to-Income (DTI) Ratio: A maximum DTI ratio of 43% is required by lenders, however, there are lenders who can go up to 50%.
- Home Appraisal: An appraisal is required to determine the value of your property
- Financials: Employment, credit records, assets, bank statements, and tax returns will be required for the refinance process.
Advantages and Disadvantages of a cash-out refinance
- Lower Mortgage Rate: In most cases, a mortgage is refinanced when the current mortgage rate is lower than the mortgage rate you were locked into when you first started the mortgage. Lower mortgage rates can save you money not only in terms of total interest paid but also with lower monthly mortgage payments. If you bought a $400,000 home in 2015 with a 30-year fixed at 4%, your mortgage payment would be $3,000. Whereas if you bought a similar valued home in 2021 at the current rate of 2.25%, your mortgage payment would be $2,625, or 12.5% lower. Use our refinance calculator to determine your total savings from refinancing.
- Consolidating Debt: If you have other forms of debt such as credit cards or student loans that have very high levels of interest, then a cash-out refinance at a lower rate can help you save on interest payments in the long-run.
- Credit Score: You can improve your credit score if you pay off your credit cards and other debt with the funds you get from the cash-out refinance.
- Tax Deductions: If the funds from the refinance are used to increase the value of the home in the form of renovations and safety standards, the interest paid on the cash-out refinance can be claimed as interest deductions. This can include adding a swimming pool, adding a fence to the boundary, roof repair, temperature control systems, and security systems.
- Collateral: It is crucial to remember that all the home equity you built up during your first mortgage is being used as the cash-out borrowing amount. In the event that you do not make your refinanced monthly mortgage payment, the lender can claim the collateral which is your home. Therefore, it is important to know the risks of using a cash-out refinance.
- Refinance Fees: In order to obtain a cash-out refinance, you need to be able to refinance your mortgage. Refinancing has closing cost fees which can range from 3% - 5% of the new loan amount.
- Mortgage Insurance: If you borrow more than 80% loan-to-value (LTV) ratio then you will be required to get private mortgage insurance (PMI). PMI protects the lender in the event that you default on your repayments. PMI fees can range from 0.4% - 2.25% of the loan amount.
Is a cash-out refinance taxable?
The cash that you receive from a cash-out refinance is not considered to be income. Instead, the cash amount is viewed as a loan. This means that you do not pay taxes on cash from a cash-out refinance.
You can use the cash received from a cash-out refinance for anything, such as paying off debt or for a vacation. In some cases, you may even deduct interest when filing your taxes if you use the cash-out refinance for home improvements, such as fixing your roof or adding an addition to your home.
Potential Alternatives to a cash-out refinance
If your objective is to borrow funds, then there are several options available:
- Home Equity Line of Credit (HELOC): If you have had a mortgage for a couple of years, you have probably increased your equity or ownership stake in the home. A HELOC lets you borrow funds against the equity that you own in the home, using the home as collateral. It works like a credit card where funds can be borrowed and repaid providing flexibility to the borrower. In order to calculate your monthly expenditure with a HELOC, use our HELOC payments calculator.
- Home Equity Loan: In this type of loan, you can borrow a lump-sum amount depending on how much equity you own in the home. It is similar to a HELOC as home equity determines how much you can borrow, and the home is the collateral. However, in a home equity loan, you receive a lump-sum amount rather than a revolving credit.
- Personal Loan: You can borrow funds without putting up your home as collateral by taking a personal loan. The interest rate charged is relatively higher than a HELOC or home equity loan as the lender has a higher risk due to the lack of collateral.
- Reverse Mortgage: In a reverse mortgage as the name suggests, the lender pays you installments, rather than you having to make mortgage payments. This type of loan is used by senior citizens who use their equity in the home to receive monthly payments by lenders, creating another source of income during retirement.