What is a Cash-Out Refi?
Updated: Dec 3, 2019
By Louis DeNicola, CreditKarma
1. What are the different types of cash-out refinance?
There are two main types of cash-out refi, but this article will focus on standard cash-out refinance.
Cash-out refinance: With this type, you can use the funds for anything you want. Limited cash-out refinance: As the name suggests, you can only use the funds from this transaction for a few, limited purposes, including paying off your closing costs.
2. How does a cash-out refinance differ from a rate-and-term refinance?
A rate-and-term refi and cash-out refi both involve taking out a new loan to pay off your existing mortgage. With a rate-and-term, you borrow about the same amount as you currently owe and try to get a lower interest rate, different term or both.
Your rate and term could also change with a cash-out refi, but the intention is to borrow more than you currently owe and use the extra cash for something else.
If you’re just looking to lower your interest rate, a rate-and-term refi may be the better option, as they tend to have lower rates than cash-out refis.
“How much you can take out could depend on your debt-to-income (DTI) ratio, how much equity you have and your credit,” says Kevin Quinn, senior vice president of retail lending at First Internet Bank. Generally, the maximum is 80 percent of your loan-to-value ratio (LTV).
For example, if your home is worth $100,000, you may only be able to borrow money to the point where your total loan amount is $80,000.
To qualify for a cash-out refinance, you’ll generally need to get your home appraised. The appraisal value may impact how much money you can take out, as it determines the home’s value for the loan-to-value ratio.
From fixing a leaky roof to upgrading windows, you may want to invest time and money in home improvements before the appraisal if you want to maximize how much you can borrow.
3. When might a cash-out refinance be a good idea?
After paying off the original mortgage and associated fees, there aren’t usually any restrictions around how you use the money you receive on a cash-out refinance. But consider carefully how you choose to spend it.
“People might regret using the money to splurge on a luxury,” says Rebekah Tardieu, a mortgage loan originator with Residential Home Funding Corp. in Parsippany, New Jersey. She suggests “trying to use the money to put yourself in a better financial position.”
For example, you could use the money to:
Consolidate higher-interest debts. A potential good use of a cash-out refi is to consolidate high-interest debt, such as credit card debts and personal loans. There’s also a potential tax benefit as mortgage interest may be tax-deductible, while interest on personal loans, credit cards and auto loans often isn’t. However, be sure to look at the total financing costs, not just the interest rate. Between closing costs and the potentially longer term, a cash-out refi might not always make financial sense.
Pay for higher education. If you have a college-aged child, using a cash-out refi could be a good alternative to taking out private student loans, which might have a higher interest rate
Make home improvements or repairs. Using the money to remodel or expand part of your home, or for critical maintenance, could pay for itself by raising the home’s value. However, don’t rely on a cash-out refi for a quick fix during an emergency. The process could take months to complete.
4. Cons of cash-out refinancing
While there may be many reasons why you want a cash-out refi, the arrangement might not always make sense. Here are a few cons to watch out for:
You could wind up with a higher interest rate. Refinancing changes your mortgage’s terms, which could include your interest rate, and you could wind up with a higher mortgage rate. “If you bought your home or refinanced in the past five years or so, you might have a 30-year fixed mortgage that’s around 3.5 percent,” says Erin Lantz, vice president of mortgages at Zillow Group. “Now you’re looking at rates in the low 4s for a cash-out refi.”
Ask yourself if losing the low rate is worth the access to cash.As with other types of mortgage refinances, cash-out refis require you to pay closing costs. The costs can vary depending on your new loan’s balance, and they could add up to hundreds or thousands of dollars. So it may not make sense to spend $2,000 on closing costs to cash out $5,000.
5. What else should you know before deciding whether to cash-out refinance?
Consider the costs, time and risk associated with a cash-out refi before going through with the process. “You should have a clear reason for why you’re doing a cash-out refinance,” says Tardieu. Otherwise, you might wind up in a worse position.
Knowing your credit scores and asking lenders what rates they currently offer could help you estimate your new mortgage’s interest rate.
Compare the new rates and terms to your current mortgage and decide if moving forward makes sense.