Home values increased drastically over the last year, leaving homeowners with much more equity than before. If you’re sitting on a large amount of equity, you might wonder if you can liquidate it.
The cash-out refinance is one way to do it, but is it worth it? Here’s what you must know.
What is a Cash-Out Refinance?
A cash-out refinance is a refinance of your first mortgage. It refinances your existing loan plus gives you access to some of the home’s equity that would otherwise stay tied up in the home.
Most loan programs allow homeowners to use up to 80% of their home equity with a cash-out refinance.
How Does it Work?
When you do a cash-out refinance, you apply for a mortgage, like you did when you bought the home. This time, however, you’ll apply for a loan amount higher than what you owe now.
For example, if your home is worth $400,000 and you have a $250,000 loan, you can borrow up to $70,000 from the home’s equity. The new lender will pay your current lender the $250,000 you owe, and you’ll receive the $70,000 in cash.
Your new mortgage payment would be on the $320,000 loan, which means a potentially higher principal and interest payment depending on your chosen loan program.
How can you use the Cash?
The good news is that lenders don’t tell you how to use the cash; they don’t mandate how you must use it. However, there is one exception; if your debt-to-income ratio is too high, the lender may require you to use the cash to consolidate your consumer debt.
If the lender doesn’t require that, you can use the cash for anything, including:
- Home improvements
- Retirement savings
- Emergency fund
- Pay off debt
You can take the money and put it in your bank account, invest it, or spend it – there aren’t any rules.
How to Qualify for a Cash-Out Refinance
Qualifying for a cash-out refinance works much like when you applied for a purchase mortgage. The exact qualifying requirements depend on the loan program and lender you choose. However, here are the basic qualifying requirements.
Most lenders require at least a 680 credit score for a cash-out refinance. Because it’s riskier for the lender to give you a higher loan amount, they must know you have a solid credit history.
If you aren’t sure what your credit looks like, pull your reports here for free. Look for any issues that could bring your credit score down, like late payments, high credit card balances, or collection accounts.
Try improving your credit before applying for a cash-out refinance to ensure you get the best rates and terms.
Low Debt-to-Income Ratio
Your DTI tells lenders how much debt you have outstanding compared to your monthly income. A high DTI, such as a DTI of over 43%, puts lenders at a higher risk for default.
Ideally, lenders want a 36% or lower debt-to-income ratio to allow you to take equity out of your home.
Your payment will likely increase with a cash-out refinance, so lenders want borrowers with stable employment. They need to know beyond a reasonable doubt that you can afford the higher payment.
Pros and Cons
Understanding the pros and cons of the cash-out refinance can help you determine if it’s a good option.
- You can use your home’s equity and keep the home. If your home is worth much more than you owe, a cash-out refinance is a great way to make that equity liquid but keep your home.
- You may get better rates or terms. Depending on the rates and terms you got when you bought the home, you might be able to get better options when you refinance. This is especially true if you’ve improved your credit or your income has increased since you bought the home.
- You might be eligible for tax deductions. For example, if you use the funds from your home’s equity to renovate your home, you may be able to deduct the interest paid on the first $750,000 in mortgage loans.
- Your interest rate might increase. If you already had a low interest rate on your loan, you might have a higher rate to compensate for the risk of a cash-out refinance, coupled with the higher interest rates that are the norm for the industry today.
- You put your house at risk. If you can’t keep up with your payments, you could risk your house in foreclosure. Cash-out refinance lenders have first lien positions and will start foreclosure proceedings if you miss too many payments.
- You might use the funds needlessly. It’s important to withdraw funds from your home’s equity for useful purposes, such as renovating the home or consolidating high interest consumer debt, otherwise, you risk wasting the money your investment earned.
A cash-out refinance can be a great solution if you need extra cash. You can use your home’s equity and get a new first mortgage. Before you choose this option, understand how your payment will change and what you’re losing by refinancing your first mortgage.
If it makes sense to tap into your home’s equity, use the cash how you see fit, and if you use any of the funds to renovate your home, make sure you get the tax break for investing back into your home.
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