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If you're a homeowner with bad credit and are wondering where you might be able to borrow some cash at a low interest rate, a cash-out refinance might be right for you.
You can most likely get a cash-out refinance if you have bad credit, but it will ultimately depend on the lender, the amount of equity you have in your home, and exactly what is bringing your credit score down.
What Is a Cash-Out Refinance and How Does It Work?
A cash-out refinance is a loan that replaces your existing mortgage—but with a little extra added on. The new loan will satisfy your old balance, and you'll get the difference in cash. You can do whatever you want with this surplus. People often use it for home improvement projects or to pay off high interest revolving debt.
To get a cash-out refinance, the first thing you will need is sufficient equity in your home. Your lender will use your equity amount to establish how much excess cash they'll give you. To get a cash-out refinance, contact your current lender or look online for other lenders you may want to work with.
These types of loans might sound like a perfect solution to someone who's strapped for cash, but there are certain pitfalls to consider. Keep in mind that any time you refinance, your new loan will have different terms, so it's important to check the details carefully, such as the new interest rate and fees. If your interest rate goes up, the value of refinancing may not be advantageous over the life of the loan.
Look out for other costs associated with cash-out refinancing as well, such as closing costs and private mortgage insurance (PMI). A cash-out refinance will have closing costs—which for home purchases are around 2% to 5% of the mortgage amount—and PMI will be charged on loans that exceed 80% of the home's value. These costs alone might make a cash-out refinance more expensive that it's worth, so make sure to dig into the loan's details before moving forward.
What Credit Score Do I Need?
Unlike other refinancing options, cash-out refinancing is open to people with fair and poor credit. While home equity lines of credit (HELOCs) and home equity loans require applicants to have minimum FICO® Scores* between 660 and 700, a cash-out refinance lender may be satisfied with less.
Because lenders that facilitate cash-out refinancing are issuing you an entirely new mortgage, they become the first party lien holder, which means if you default, they have clear access to your property to recoup their investment. In other types of home equity options, the new lender may only have claim to the equity against which you are borrowing—meaning if you default, the new lender will have to compete with another lender to get their investment back.
This difference may make a lender more willing to take on someone with a lower credit score for a cash-out refinance, but does not mean they will give these loans to everyone. If you have a substantial history of missed payments or any glaring blemishes in your credit file, creditors may think twice about issuing you new debt.
Be Careful Using a Cash-Out to Pay Off Debt
The good thing about cash-out refinancing is that you can do whatever you want with the excess cash. But be careful. Most important, know that if you use your new cash to pay off other debt—like credit card debt—you are putting your home up as collateral. This means if you default on your new and larger payment, you risk foreclosure and the loss of your home.
Credit card debt is considered unsecured, because the lender has no collateral to hold on to if you stop making payments. When you use a cash-out refinance to pay off unsecured debt, you are essentially converting it to secured debt—giving the lender collateral (your home) they can take in the case that you default. Depending on your financial situation, this move might be fine. Be sure to always make your payments on time and plan your finances ahead of time to avoid getting into a situation that could result in a lender foreclosing on your property.
Options Other Than a Cash-Out Refinance
If a cash-out refinance isn't for you, there are several other refinancing options you could look at, including a home equity line of credit and a home equity loan.
As you pay your mortgage, the money paid toward the principal converts into equity—which is the value of your property you actually own. A home equity line of credit, or HELOC, is a line of credit issued by a lender that is based on the equity you have in your home. Depending on the lender, you may be eligible for a line of credit equal to around 60% to 85% of your equity.
A home equity loan is similar to a HELOC, but with one key difference. When you get a HELOC, the line of credit can be used almost like a credit card: borrow what you want, when you want. A home equity loan is more like a personal loan, in which you get paid a lump sum and then repay it over a fixed period of time.
In the case of the HELOC, the interest you pay will be variable, similar to a credit card's, but will only be based on the amount of credit you use. With a home equity loan, the interest rate will be fixed and paid out over the course of your pre-established repayment plan.
Do your research when choosing between a HELOC and a home equity loan. And as always, if you are considering refinancing your mortgage using any of these options, make sure to check your credit reports and scores so you know what lenders will be using when they consider you for a new loan.
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Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.
*Credit score calculated based on FICO® Score 8 model. Your lender or insurer may use a different FICO® Score than FICO® Score 8, or another type of credit score altogether. Learn more.