Paying off your mortgage helps build home equity (one of the reasons mortgages are considered “good” debt). But you don’t have to wait until you pay off your mortgage in full or sell your home to acquire that equity. You can convert your existing equity into cash and continue to pay your mortgage with a cash-out refinance.
What is cash-out refinancing?
A cash-out refinance is a mortgage refinance option that allows you to convert home equity into cash. The new mortgage will exceed your previous mortgage balance, and you will pay the difference in cash.
Generally speaking, in the real estate world, refinancing is a popular process of replacing an existing mortgage with a new one, often with better terms for the borrower. Refinancing your mortgage allows you to reduce your monthly mortgage payments, negotiate lower interest rates, renegotiate term loan terms, remove or increase borrower loan obligations, and, if paid off, refinance benefits from your Get cash out of your home equity.
How does a cash out refinancing work?
The process of a pay-to-pay refinance is similar to a regular mortgage refinance (also known as a rate-and-term refinance), in that you simply replace your existing loan with a new one, usually with a lower interest rate or shorter repayment term, or both. However, with a cash-out refinance, you can also withdraw some of your home’s equity at a time. Therefore, your new loan amount will be higher – an amount equal to the equity you withdraw.
Let’s say your current mortgage balance is $100,000 and your home is currently worth $300,000. In this case, you have $200,000 in home equity. Let’s say by refinancing your current mortgage, you can get a lower interest rate and use that money to renovate your kitchen and bathroom.
Lenders typically require you to keep at least 20% of your home equity after you pay for a refinance (although there are exceptions). So, using our example above, you must have at least $60,000 in home equity or be able to borrow up to $140,000 in cash. You’ll also have to pay closing costs on the new loan, such as administration fees and appraisal fees (yes, the lender will appraise your home). As a result, the ultimate cash you get from refinancing may end up being substantially less than your equity is actually worth.
After refinancing, you tend to pay more in interest because you increased the loan amount. Otherwise, the steps for this type of refinancing should be similar to your first mortgage application.
How to Prepare for a Cash-Out Refinancing
This is how you can prepare to refinance with spending.
Determine the Lender’s Minimum Requirements
Mortgage lenders have different eligibility requirements for paying off refinancing, and most have a minimum credit rating of at least 620—the higher the better—though some will accept credit ratings as low as 580. Other typical requirements include a debt-to-income ratio of less than 43% (50% in some cases) and at least 20% home equity. As you explore options, be aware of the requirements.
Determine the amount of cash you need
If you’re considering refinancing with a withdrawal, you may need funds for specific purposes. If you’re not sure what that is, it might help to pin it down so you can only borrow as much as you need. For example, if you plan to use cash for debt consolidation, gather your personal loan and credit card statements or information about other debt obligations, then add up your debts. If the money is going to be used for renovations, contact some contractors to estimate labor and materials in advance.
Prepare your cash-out refinancing application
After checking out several lenders to ensure you get the best rate and terms, prepare all financial information related to your income, assets and debts for the application. Keep in mind that you may need to submit additional documents while the lender reviews your application.
Pros and Cons of Cash-Out Refinancing
Savvy investors who track rates over time often jump at opportunities to refinance when lending rates hit new lows. There are many different types of refinancing options available, but usually most come with some additional costs and fees that make the timing of refinancing your mortgage just as important as the decision to refinance.
Not only should you consider interest rates and fees to make sure refinancing is a good option, but also why you need the cash. Interest rates on this refinancing option are usually lower than on unsecured debt like credit cards or personal loans. However, unlike a credit card or personal loan, you run the risk of losing your home — for example, if you can’t make your mortgage payments, or if your home’s value drops and you find yourself in trouble on your mortgage.
Consider carefully whether what you need the money for is worth the risk of losing your home if you can’t keep up with payments in the future. When you need money to pay off consumer debt, take the necessary steps to control your spending so you don’t get caught in an endless cycle of debt accumulation. The Consumer Financial Protection Bureau (CFPB) has many excellent guides to help you decide if refinancing is right for you.
A cash-out refinance offers borrowers all the benefits they expect from a standard refinance, including lower interest rates and other potentially beneficial changes. Borrowers also receive cash payments that can be used to pay off other high-interest debt or potentially finance a larger purchase.