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A cash-out refinance lets you cash in on the equity you've accumulated in your home. You can spend the lump sum of money you gain from the refi on pretty much anything you want. A cash-out refinance might be a good way to pay for a home improvement project, debt consolidation or unexpected car repairs, for instance.
However, a cash-out refinance isn't always the best route to take when you need extra money. Cash-out refinancing has some disadvantages versus other forms of borrowing, including hefty closing costs and a potential home foreclosure. For these reasons and more, a personal loan or other borrowing options might be preferable as ways to slash high-interest debt or make a large purchase.
Before you settle on a cash-out refinance, consider the pros and cons, and weigh all of your options. You want to make sure your refinance isn't creating more problems than it solves.
What Is a Cash-out Refinance?
A cash-out refinance replaces your existing mortgage with a new home loan that exceeds the amount you owe on your house. You then can tap into the difference between the value of your home and the amount you owe as a cash payout. You can spend the cash on debt consolidation, home improvements and a variety of other needs.
Usually, a lender restricts the amount you can borrow through a cash-out refinance to about 80% of the equity you've built in your home. So, if your home is valued at $250,000 and you still owe $150,000, the maximum cash-out finance loan amount might be $200,000, with $50,000 of it going to you in cash.
A lender hands you the money from a cash-out refinance, which comes with a fixed interest rate or adjustable interest rate, in a lump sum. That sum is left over after the initial mortgage is paid off and closing costs are covered.
Here are some of the typical criteria to qualify for a cash-out refinance:
- A minimum credit score, which could range from 600 to 640. In some cases, though, you might be able to obtain a cash-out refinance loan with a credit score as low as 580. Keep in mind that credit score requirements vary from lender to lender.
- Debt-to-income ratio of less than 50%. How do you calculate this ratio? Divide your monthly debts and bills by your monthly income.
- Sufficient amount of home equity (normally at least 20%).
- You must have owned your own for at least a certain length of time.
What Do People Use a Cash-Out Refinance For?
People use a cash-out refinance for a variety of reasons. They include:
- A lower mortgage interest rate. With a cash-out refinance, you might be able to swap out a higher original interest rate (like 5%) for a lower one (like 3%).
- Home improvement projects like a kitchen remodel, a replacement HVAC system or a new patio deck. If you put the cash-out proceeds toward a project that increases the value of your home, the mortgage interest is tax-deductible.
- Emergency expenses, such as an unexpected hospital stay or unplanned car repairs.
- Education expenses, such as college tuition.
- Consolidating and paying off high-interest credit card debt.
Will a Cash-Out Refinance Affect Your Credit Score?
A cash-out refinance can affect your credit score in several ways, though most of them minor. Some of them are:
- Submitting an application for a cash-out refinance will trigger what's known as a hard inquiry when the lender checks your credit report. This will lead to a slight, but temporary, drop in your credit score.
- Shopping around can cause a decline in your credit score. If you apply with several lenders in search of the lowest interest rate over a roughly 14- to 45-day period, the impact on your credit score could be minimal. That's because most credit-scoring models look at this as one inquiry rather than several inquiries. However, if you spread out the applications over a period of months, your credit score could suffer.
- Replacing your old mortgage with a new mortgage will lower the average age of your credit, possibly translating into a dip in your credit score. But if you established a solid payment history with the old mortgage, your credit score might see only a small, temporary decrease if any.
Is It a Good Idea to Get a Cash-Out Refinance?
A cash-out refinance may be helpful in certain situations.
- It could lower your interest on the loan. If you're considering a cash-out refinance, getting a lower interest rate should be a main goal. And, depending on how much cash you plan to take out, a lower interest rate could save you money over the life of the loan.
- If you plan to make home improvements that will increase your home's value, a cash-out refinance may provide a larger loan than you could get otherwise, often at a lower interest rate than you could find with a personal loan, home equity loan or credit cards. You may also be able to get a tax break using the mortgage interest deduction depending on your project.
- Using a cash-out refinance to help pay college costs for your child could help you cover gaps in financial aid or provide cash at a lower interest rate than a student loan.
While a cash-out refinance can benefit your finances, there are drawbacks.
- You could lose your home. Because your house serves as collateral for the loan, you might face foreclosure if you fall behind on mortgage payments.
- Closing costs could add up to thousands of dollars. Closing costs, such as the loan origination fee, can wind up being 2% to 5% of the amount you've borrowed. These costs could wipe out any money you hoped to save through refinancing at a lower interest rate depending how long you plan to stay in the house.
- Various fees could be attached to the loan. This might include a penalty for paying off your mortgage early. The fee could equal one to sixth months' worth of interest payments.
- You could end up worse off if you use the money to pay off high-interest credit card debt—and then run up the balances again. In that case you'll be paying for the new, higher mortgage and high interest on your credit cards, leaving you in a worse situation than before you got the loan.
Alternatives to a Cash-Out Refinance
If, like many other people, considering a cash-out refinance to take a bite out of higher-interest debt, you should know that several other options are available. Here are six alternatives to explore:
- Personal loan: A lot of people take out personal loans to consolidate and chip away at their credit card debt. A personal loan, which typically doesn't require any collateral, often carries an interest rate that's lower than what's charged on credit card debt.
- Home equity loan: This type of fixed-rate loan lets you borrow against a chunk of your home equity. Interest rates for home equity loans typically are lower than they are for personal loans and credit cards. Keep in mind that you'd be trading unsecured credit card debt for debt that could jeopardize ownership of your house if you're experiencing financial trouble the same way you would with a cash-out refinance.
- Home equity line of credit (HELOC): Similar to a home equity loan, a HELOC allows you to tap into your home equity. But these two loans differ in one key way. A home equity loan (like a cash-out refinance) gives you access to a lump sum of money, but a HELOC gives you a line of credit that you can borrow against whenever you choose. In that regard, a HELOC is like a credit card.
- Debt snowball and debt avalanche methods: These two approaches can help you get out of debt. With the debt snowball method, you initially focus your energy on paying down the cards with the lowest balances before moving on to those with the higher balances until all of your credit card debt is erased. The debt avalanche method prioritizes paying off higher-interest debt first, then moving on to the lowest-interest debt.
- Help from creditors: When you find yourself drowning in credit card debt, one of the smartest things you can do is to contact your credit card issuers. You might be able to negotiate a reduction in your interest rates, lower monthly payments or paused payments in the quest to ease your financial burden.
- Credit counseling: Feeling crushed by your credit card debt? Then it might be time to reach out to a nonprofit credit counseling service. One of the service's specialists can assist with debt management, debt consolidation or debt settlement, all of which can put you on the path toward being debt-free. A specialist also can work with you to come up with a household budget.
The Bottom Line
A cash-out refinance enables you to take advantage of the value of what's likely your most valuable asset—your home. Borrowing against your home's equity can free up money to cover college tuition, a kitchen remodel or many other financial needs. Plus, you might qualify for a tax deduction on the interest paid on a cash-out refinance mortgage. Yet swapping your equity for cash could be costly. For instance, it might lead to thousands of dollars in closing costs and might endanger ownership of your home.
Taking out a cash-out refinance shouldn't be a hasty decision. Give careful thought to the upsides and downsides of trading your equity for a lump sum of money, and put all of your options on the table. You might find that a cash-out refinance could turn the tables on your finances in either a positive or negative manner.