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A cash-out refinance is a type of mortgage refinance loan that allows you to tap some of the equity in your home if you need extra cash. You may consider it if you want to consolidate debt, finance home renovations or pay for other large expenses.
There are some potential disadvantages of getting a cash-out refinance, however, especially if your budget doesn't have a lot of room for a higher monthly payment. Here's what to consider before you apply for a cash-out refinance.
What Is a Cash-Out Refinance?
For the most part, a cash-out refinance works similarly to a traditional mortgage refinance loan. Both processes replace your existing mortgage with a new one that may come with a new interest rate, repayment term, monthly payment and more.
The primary difference is that a cash-out refinance loan will be larger than the remaining balance on your mortgage—allowing you to pocket the difference in cash. Even if you qualify for a lower interest rate, a cash-out refinance will typically raise the lifetime cost of your loan.
You can use your funds from a cash-out refinance for just about anything you want. Some of the more common reasons include home improvements, debt consolidation and other major expenses.
How Much Can You Get From a Cash-Out Refinance?
You typically need to have a significant amount of equity in your home to qualify for a cash-out refinance loan. Lenders usually only allow you to borrow up to 80% of your property's value, including both the existing loan balance and the amount you want to take out in the form of cash.
For example, let's say you have a $250,000 mortgage balance on a home worth $400,000. With a cash-out refinance, you may be able to get up to $70,000 in cash, resulting in a new loan of $320,000.
The actual amount you qualify for can vary depending on the lender, your creditworthiness and other factors.
Pros and Cons of a Cash-Out Refinance
A cash-out refinance can help you out in a pinch, but there are some important downsides to consider before you pull the trigger and apply. Here are the advantages and disadvantages to keep in mind.
- Relatively low interest rates: Compared to credit cards and other unsecured loans, you can usually get a lower interest rate with a cash-out refinance. This could allow you to use one to pay off high-interest debt.
- Possible boost in your home's value: If you use your cash to make some improvements to the home, you may be able to increase the value of the property.
- Potential tax benefits: If you use the funds you receive to buy, build or substantially improve your home, you may be able to deduct the interest you pay on the cash portion from your income when you file your tax return every year. Additionally, those improvements will increase your tax basis, which can save you money on capital gains tax when you eventually sell the home.
- Higher payment: Even if you can secure a lower interest rate than what you're paying now, your monthly payment may end up being higher and could strain your budget. If you struggle with the higher amount, you could risk foreclosure.
- Closing costs: You can expect to pay between 2% and 6% of your new loan amount in closing costs, which can easily amount to several thousand dollars in upfront out-of-pocket expenses.
- Doesn't change spending habits: If you're thinking of using a cash-out refinance to consolidate credit card debt, you may be enabling poor spending habits to continue unless you have a plan to avoid racking up a new balance on your credit card accounts.
- Puts your home at risk: Since your home serves as collateral on a mortgage loan, you could be putting your home at risk of foreclosure if you're unable to pay your new loan amount.
How to Qualify for a Cash-Out Refinance
A cash-out refinance loan generally comes with the same eligibility criteria as a traditional mortgage refinance loan:
- Equity: The main difference is that you typically need to have more than 20% equity in your home to obtain a loan—with traditional refinance loans, your loan-to-value ratio (LTV) may not be a deal-killer unless it's close to 100%.
- Credit: Lenders typically have a minimum credit score of 620. However, they'll also consider your full credit history to make a final decision.
- Debt-to-income ratio (DTI): The sum of your total monthly debt payments should be less than 50% of your gross monthly income.
- Other requirements: Lenders will also consider your income sources, employment history and other factors to determine your eligibility.
Every lender has its own set of credit criteria, so work directly with lenders through the preapproval process to determine your eligibility. And while it's possible to get a cash-out refinance with bad credit, there may be additional requirements to mitigate the risk to the lender (such as a higher interest rate).
Alternatives to a Cash-Out Refinance
Depending on why you're considering a cash-out refinance, you may have several appealing options to save or borrow money. Here are some to consider:
Personal loans are a versatile form of borrowing you can use to cover a wide variety of expenses. A personal loan can be a good option for debt consolidation, home improvements and other major expenses.
One of the benefits of personal loans is that they're typically unsecured, so you don't risk losing any of your big personal assets, such as your home or vehicle, in the case of default. However, because there's no collateral, their interest rates can be higher than you could get through a cash-out refinance.
Home Equity Loan or Line of Credit
Another way to tap your home's equity at a lower cost is through a home equity loan or a home equity line of credit (HELOC). Unlike a cash-out refinance, these are second mortgage loans that you can use to consolidate debt, finance home renovations or pay for other large expenses.
While the closing costs may be charged at a similar rate, you'll only pay them on the amount you actually borrow, not your full mortgage balance. Also, some may not charge closing costs at all. However, they typically charge higher interest rates because of their junior position to your primary mortgage in the event of default and foreclosure.
Debt Snowball or Avalanche Methods
If you're considering a cash-out refinance to pay down debt, the debt avalanche and snowball approaches can save you money on interest and create more cash in your budget over time.
The debt snowball method works by having you pay just the minimum on all your debts except for the account with the lowest balance. You'll put as much as you can toward that balance to pay it off more quickly. Once it's paid off, take what you were putting toward that debt every month and add it to the monthly payment you were making on your next-lowest balance. Continue the process of paying off your accounts until you're debt-free.
The debt avalanche method is a similar strategy but targets your balances with the highest interest rates first. With this approach, you may be able to save more on interest versus the debt snowball method. But if you're struggling to stay motivated with your debt payoff, the snowball approach may give you more wins early on.
Get Your Credit in Shape Before Applying
Even if you qualify for a cash-out refinance—or any other financing option—with a relatively low credit score, it may be a good idea to wait until you've had time to work on improving your credit.
Start by checking your credit score and credit report to get an idea of where you stand and which areas you need to address. Then take the time to work on fixing some of the issues that could prevent you from scoring a lower interest rate and better terms overall.
The process of improving your credit score can take some time, but if your need for cash isn't urgent, taking these steps could ultimately save you more money in interest charges on your new loan.