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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.
How Does a Cash-Out Refinance Work?
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, 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.
Here's how the cash-out refinance process might work. Let's say you have a $250,000 mortgage balance on a home worth $400,000. You need $20,000 to cover the cost of some home renovations, so with a cash-out refinance loan, you replace your $250,000 loan with a $270,000 loan and receive the $20,000 difference in cash.
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.
That said, there's no guarantee you'll get the amount you want. Many lenders allow you to borrow up to 80% of your home's value. So if you have a $400,000 home, the maximum amount you could borrow with a cash-out refinance is $320,000, but you may be limited by other factors including how much equity you have in your home.
Drawbacks of a Cash-Out Refinance
While doing a cash-out refinance can help you improve your financial situation, there are some potential pitfalls that can make it difficult to justify:
- Collateral issues: As cash-out refinancing uses your home's equity as collateral for the debt, you could risk losing your home to foreclosure if you struggle to make your new, higher mortgage payment.
- 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. The amount you'll pay to refinance will play a big role in determining whether a cash-out refinance is the smart move. Don't forget to compare the benefits with these costs to ensure it's a good fit for you.
- New loan terms: Your cash-out refinance loan may give you more or less time to repay the debt than your old mortgage did. If you opt for a longer term on your new loan, that likely means paying more interest in the long run.
- 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.
When It Makes Sense to Get a Cash-Out Refinance
A cash-out refinance may make sense if you want to leverage the equity you have in your home to improve your overall financial situation.
For example, using the money to pay off high-interest debt could save you money on interest charges and provide you with a little budget relief. And if you're thinking of making improvements to your home, using a low-interest cash-out refinance could make it possible to do the work and increase the value of your home.
Other potential options include using the money to save for a child's education, bolstering your emergency fund or paying for other major expenses.
It may also be a good idea to get a cash-out refinance if you're getting a divorce and want to buy yourself or your ex-spouse out of the home.
Because of the amount of time it takes to refinance a mortgage, it may not be a great way to cover an emergency expense that needs to be taken care of immediately.
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.
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%.
In addition to your LTV, lenders will also consider other factors, including your credit score, debt-to-income ratio, how long you've been living in your home, your job history and more.
This means that if your credit score has decreased since you first bought the house, you have more debt or your job situation is a bit shaky, it could make it challenging to get approved for a cash-out refinance. On the other hand, if your situation has improved, you may end up getting a better interest rate on your cash-out refinance loan than you had on your original loan.
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 the lender is taking on.
Alternative Options for 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, but there are some restrictions to keep in mind (many lenders won't let you borrow to cover college expenses, for instance). Securing funding through a personal loan issuer 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 separate loans that you can use to consolidate debt, finance home renovations or pay for other large expenses.
Also, while the closing costs are charged at a similar rate, you'll only pay them on the amount you actually borrow, not your full mortgage balance. A HELOC and a cash-out refinance are similar, though, in that they both use your home's equity as collateral, so non-payment could result in foreclosure.
Debt Snowball or Avalanche Methods
While the debt and snowball approaches to paying down debt won't give you an immediate cash infusion, they 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.
Work With Your Creditors
If you're struggling to make payments, contact your creditors to see what relief options they might be able to offer you. If you've been paying your bills on time and generally have good credit, check to see if you can get a lower interest rate from your current lender or through a different one.
If your debt situation is dire but you want to avoid bankruptcy, consider contacting a credit counselor. They may recommend a debt management plan, which typically runs three to five years and allows you to make just one monthly payment to the credit counseling agency for all of your unsecured debts. The agency, in turn, pays your lenders directly.
These agencies may also have the ability to negotiate a lower interest rate or lower monthly payments to make things more affordable for you.
You'll need to pay a modest upfront fee and low monthly fees to cover the costs associated with the plan, but these fees can easily be worth it compared with the alternative.
Make Sure Your Credit Is Right 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.