September 27, 2022

These Are the Pros and Cons of a Cash-Out Mortgage Refinance

If you’ve been paying your mortgage for a number of years or your home has appreciated in value, a cash-out mortgage refinance lets you access some of the value stored in your home. With a cash-out refinance, you’ll get a new mortgage for more than you currently owe, allowing you to keep the difference as cash.

A cash-out refinance can be a good idea if you have a good reason to tap the value in your home, like paying for college or home renovations. A cash-out refinance works best when you are also able to score a lower interest rate on your new mortgage, compared with your current one. That may be tough to do in a rising-rate environment like today. So, when does it make sense to consider a cash-out refinance?

What Is a Cash-Out Refinance?

A cash-out refinance is when you take out a new mortgage to repay your existing mortgage and the new mortgage is for more than you owe on your existing mortgage. The difference is paid out to you in cash.

Cash-out refinances allow homeowners to tap into their home equity to pay for things like medical expenses, home improvements, debt consolidation and other big purchases.

In 2021, 42% of all refinances were cash-outs, according to Freddie Mac, likely due to low interest rates at the time, which made refinancing a great deal. Average rates have been on the rise throughout 2022, however, exceeding 6% for the first time since 2008 on Sept. 15, 2022.

While rates might be higher, homeowners are still building equity in their homes. In the second quarter of 2022, mortgaged homes saw their equity increase by 27.8% compared with the year prior, according to CoreLogic. That’s an average increase of $60,200 per borrower in one year. With more equity to work with, cash-out refinancing could still be worthwhile for some people.

No matter the economic climate, understanding the benefits and drawbacks of cash-out refinances and crunching your personal numbers is important before you move forward.

How a Cash-Out Refinance Works

A cash-out refinance works similarly to a regular refinance except that the amount of home equity you have plays a bigger role. Lenders typically will approve a cash-out refinance up to 80% of the appraised value of your home. This is known as the loan-to-value ratio. (A regular refinance can usually have a higher LTV.)

Sean Grzebin, head of consumer originations for Chase Home Lending, shares this example: Say your home is appraised at $200,000 and you owe $100,000 on your mortgage. That means you have $100,000 in home equity. With a maximum LTV of 80%, your new loan can go up to $160,000. Paying off your existing mortgage would leave you with about $60,000 in cash (less any fees or closing costs if you roll those into the loan).

Cash-Out Refinance Requirements

Getting approved for a cash-out refinance is not all that different from doing a regular refinance, but some lenders may hold you to higher standards, says Grzebin. “Cash-out refinances typically require a higher credit score and lower loan-to-value ratio to ensure a customer’s ability to repay the loan with higher monthly mortgage payments,” he says.

In addition to meeting the lender’s debt-to-income ratio, credit score and income standards, you may also need to provide a “cash-out letter,” says Nicole Rueth, senior vice president for The Rueth Team at OneTrust Home Loans. “It’s an additional document that is required for the loan that simply states your intention for the use of the cash. It could be as simple as debt consolidation or remodeling of the home,” says Rueth.

One other consideration is that you will usually not get an appraisal waiver with a cash-out refinance, adds Rueth.

How Much Money Can You Get From a Cash-Out Refinance?

The key number to remember with a cash-out refinance is an 80% loan-to-value ratio since that’s the loan limit set by Fannie Mae and Freddie Mac. In other words, you can borrow up to 80% of your appraised home value. The more equity you have to begin with, the more cash you’ll be able to take out.

Some lenders also have caps on the amount of cash you can receive, even if your LTV would be under 80%. Make sure to ask as you are evaluating different lenders.

Pros and Cons of a Cash-Out Refinance

Pros 

  • Better rates. If interest rates are lower than what you are currently paying, or if your financial situation has improved so that you could qualify for better rates and terms, then a cash-out refinance could be beneficial, says Grzebin.
  •  Lower monthly bills. If you decide to use a cash-out refinance for debt consolidation, you may be able to lower your overall monthly expenses and relieve some financial pressure. This is especially true if you have high-interest consumer debt.
  • More cash on hand. If a cash infusion would help you meet a personal financial goal, whether it’s a home renovation or paying a medical bill, a cash-out refinance can provide the money you need. Funds from a cash-out refinance can also be used to buy out a share of a property from another, which is why it is a popular tool for divorced couples. 

Cons

  • Too much debt. In the event that your life circumstances change after a cash-out refinance, you could end up putting your home at risk if you can’t afford to pay for the new loan.
  • Higher payment. A cash-out refinance could result in higher payments than your previous mortgage, especially if you aren’t able to score a lower interest rate. “Cash-out refinances may also require a slightly higher interest rate than standard refinances,” says Grzebin. 
  • Going upside-down. If your home value decreases, a cash-out refinance could result in your owing more than the home is worth. With today’s 80% LTV requirement, however, Rueth says that risk is lower now than it was before the 2008 mortgage crisis, when lenders allowed for more aggressive borrowing.

Cash-Out Refinance Alternatives 

If you need cash but don’t want to go the cash-out refinance route, you do have other options that allow you to take advantage of your home equity.

Home Equity Line of Credit

A HELOC exists as a separate loan, creating a second lien on the property. It’s not actually a loan, though; it’s a line of credit that you can draw from as needed. Closing costs are minimal. For the first five or 10 years (depending on the terms), you only have to pay back the interest on the amount you borrow, or a small minimum payment. After that period, you must begin paying back the principal plus interest.

The downside is that the interest rate is variable and tied to the prime rate. “As the Fed rate is going up and it’s expected to go up over 4%, then those home equity lines of credit will also go up. Probably to 6% or may even touch 7%,” says Rueth. “So that higher interest rate on that variable line could be painful as that mortgage payment fluctuates.”

Home Equity Loan

A home equity loan is another name for a second mortgage. You take out a second loan against your home equity, so you’ll have an additional payment to make each month. The appeal of a home equity loan is that you can opt for a fixed interest rate. The key to making this product work for you is making sure you don’t borrow more than you can afford to pay back.

Cash-Out Refinance HELOC Home Equity Loan
One loan payment Two loans to pay back Two loans to pay back
Usually fixed rate Variable rate Fixed rate
Lump sum Line of credit to be used as needed Lump sum
Easier to manage More flexibility as to how much you borrow Predictable cost
Higher closing costs Lower or no closing costs Lower or no closing costs

Is a Cash-Out Refinance a Good Idea?

“A cash-out refinance can be productive – even in a rising-interest-rate market – when the long-term circumstances suggest success,” says Rueth.

For example, if you have large amounts of high-interest debt, consolidating it could help you in the long run. “Typically in a higher-mortgage-rate environment, you also have a rising consumer debt in interest rate. So if that’s the case, consolidating the debt into a long-term, fixed mortgage product could make a lot of sense,” says Rueth.

The other main factor when considering a cash-out refinance is how much equity you have in your home. Since home values have risen considerably, it could be a good time to act for some people. “We have opportunities today that many families might not have had as little as two years ago,” says Rueth.

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