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How Does a Cash Out Refinance Work?

by | Jan 14, 2020

What is a cash-out refinance?

Cash-out refinancing means that you will refinance your existing mortgage with a new mortgage for more than you owe on your house. You are then paid the difference between your current mortgage balance and home value. Given this, you will need to have equity already built up in your house. According to Freddie Mac’s 2019 Quarterly Refinance Statistics, “cash-out” borrowers represent 83% of all conventional refinance loans, which is the highest share since the third quarter of 2007. Cash-out refinances traditionally have higher interest rates due to having a higher loan amount and limit the amount of cash out you can take to 80-90% of your house’s equity. Other factors can also come into play as well such as if the home is a single-family residence, the LTV (loan-to-value ratio) and even whether there is another loan on the property.

How much can I cash out from my refinance?

Given the fact that you can typically only take 80% of your home’s equity, here is a good example of the cash you can get from a cash-out refinance:

Your current home is valued at $250,000 and you have a mortgage balance of $150,000. Now you can take out a mortgage balance of $200,000, getting $50,000 in cash to do what you want with it because the new loan is 80% of your home’s current value of $250,000.

The difference between a cash-out refinance and traditional refinancing is that with the traditional refinance, you are just replacing your existing home loan with a new one with the same loan balance.

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When To Cash-Out Refinance?

The best time to take a cash-out refinance is if mortgage rates are low and you can get a good interest rate on your new loan and can use the money in a way to potentially build more equity into your home. One way to do this would be for home renovations that can improve your home’s value. Another time to refinance is when you are using the money to consolidate your debt, as you can typically get a better interest rate through a cash-out refinance than you could through a personal loan or credit card.

How Long Does a Cash-Out Refinance Take?

A cash-out refinance is typically faster than a HELOC or Home Equity Loan and could take at least 30 to 45 days, but each person’s timelines vary and depends on certain factors. Some factors lenders tend to take into consideration include the verification of your personal information, as well as the speed of the lender you are getting your cash-out refinance through. The cash-out refinance process can be done online, but delays can occur due to documentation verification, such as income history or home value information. If you are proactive with all your paperwork and your lender is responsive, this process could be quicker. Another factor of approval time is your credit. Typically, the higher your credit score the faster you could be approved, as there will be less verification need with lower credit scores or limited credit history.

What Do You Typically Need to Apply For a Cash-Out Refinance?

Credit Score

Typically, you will need a credit score of 600 or higher depending on the lender

Proof of Income

Depending on the lender, you will need to provide your pay stubs and current tax forms like a W2 and 1099. Additionally, you may be asked to provide your bank statements and/or proof of additional income such as investments or rental income.

LTV

You will need to show proof of having a loan to value ratio of 75% or lower. To do this you may need to provide statements for your debts including student loans, auto loans, high-interest credit cards, other mortgage loans, etc.

Late Payments

Demonstrate that you had no late payments for the past 6 months

Home Appraisal

You will need to verify the value of your home via a home appraisal to truly understand the amount of cash you will be able to take out of your home.

Home Ownership Documents

You may be asked to provide proof of title insurance and/or mortgage statements.

Is a Cash-Out Refinance a Good Idea?

A cash-out mortgage refinance is a good idea if you are able to both get a better a rate on your original mortgage and combine it with getting cash that can help pay for major expenses that can greatly improve one’s financial well-being. The most common uses of a cash out refinance include the following:

Lowering Your Current Interest Rate

The best reason to get a cash-out refinance is the same as why most people do a traditional refinance and that’s to lower your interest cost while taking on a larger loan. This is when you can get a lower rate than on your original loan, depending on whether you qualify for a lower rate with lenders.

Home Improvement

Homeowners can use cash-out mortgage refinancing to make improvements to their home that could increase their home’s value. By using your home’s equity, you could get a better rate than other forms of financing which includes credit cards, home equity loans or personal loans, depending on the lender. Further, these home improvement projects could allow homeowners to deduct the mortgage interest from their taxes.

Debt Consolidation

If you can reduce the interest rate of your primary mortgage and, in combination, take out money to pay down your high-interest debt, a cash-out refinance could make sense for you. Most likely, these high-interest debts will be at an interest rate much higher than the interest you would get when refinancing your home.

College Education

If you have a kid that is looking to attend college, it could be a smart move to use your home’s equity to pay for their education rather than get a student loan where the rates may be much higher.

Do You Pay Taxes on the Cash Taken Out of a Cash-Out Refinance?

Typically, you are allowed to deduct the interest paid on up to $1 million in mortgage debt on your primary or secondary home (or both combined) when refinancing as a couple and $500,000 as a single. If you are single and are taking money out of your home via a cash-out refinance, you can deduct the interest on up to $500,000 if you use the money on home improvements or repairs.

However, if you are taking money out for something OTHER THAN home improvements and/or repairs, then it is no longer qualified as mortgage debt and looked at as a home equity loan for tax purposes. This means that the interest paid on this type of cash-out refinance is only tax deductible up to a maximum of $100,000 for a couple and $50,000 for a single.
Here is a great example of how this works:

Person A: Owes $300,000 on their mortgage. Takes a Cash-Out Refinance for $375,000 and uses that to improve their kitchen. The mortgage paid on the full $375,000 is tax-deductible as they are below the limit of $500,000 for single homeowners.

Person B: Owes $300,000 on their mortgage. Takes a Cash-Out Refinance for $375,000 and uses this to consolidate their outstanding credit card debt. They would only be able to deduct the mortgage interest on $50,000 of the new debt, but the $25,000 leftover would NOT be tax-deductible.

Are Cash-Out Refinance Rates Higher Than Traditional Refinance Rates?

Cash-out refinance rates are no different than traditional refinance rates when offered by a common lender, but different factors can affect what rate you are offered for a refinance. The difference between the two lies in the fact that you will be tapping into your home’s equity to take out a larger loan to get cash, typically for a major expense.

What are the Differences Between a Cash-Out Refinance and a Home Equity Loan and HELOC?

The big difference between a cash-out refinance loan and home equity loans is that a cash-out refinance takes your current mortgage and converts it into a larger mortgage, whereas other home equity loan options create a second mortgage on your home. A Home Equity Line of Credit (HELOC) acts as a second mortgage and allows you to withdraw the money you want as you need it and only repay the amount you borrow, while a cash-out refinance is a lump sum.

Here are some key comparison points:

Borrowing Limits

Cash-Out Refinance allows you to borrow against 80% of your home’s value whereas HELOCs allow you to borrow up to 85% of your home’s value.

Amount you could get at closing

With a Cash Out Refi, you get a lump sum at closing (usually up to 45 days). With a HELOC, you get access to a line of credit that you can take out at your discretion (usually under 30 days).

Closing Costs

Cash-out refinances have closing costs that range from 2-5% depending on the lender. HELOCs, on the other hand, have little to no closing costs.

Loan Term

With a cash-out refinance, you can select your loan term, choosing among popular options such as a fixed-rate mortgage of 15 or 30 years or variable rate mortgage with a 5/1 ARM. Most HELOCs come with a draw period of up to 10 years.

In a nutshell, a cash-out refinance may be better for you than a HELOC if you prefer the stability of a fixed monthly payment, what you save by refinancing outweighs refinancing fees and your current home loan has a higher rate than you could qualify, for now, saving on interest. A HELOC is better if you want to stick with your current mortgage due to having a lower interest rate than you could get today, you like the flexibility of having a line of credit you can borrow against and you want to borrow against 85% of your home’s equity vs. 80% you would get with a cash-out refinance.

Can You do a VA Cash-Out Refinance?

If you meet the VA loan requirements, you could get a VA loan cash-out refinance which would allow you to pocket up to 100% of your home’s value. The VA cash-out allows you to also receive cash at the closing of the loan and refinance a non-VA loan. Further, the VA cash-out refinance, like all VA loans, requires no mortgage insurance.

Paying Too Much for Your Mortgage?

Connect with lenders that specialize in VA Refinancing at VeteranLoansOnline to see if you can lower your monthly payment 

Can You Do a Cash-Out Refinance On Rental or Investment Properties?

For an investor, a cash-out refinance is a great tool. A cash-out refinance can help you maximize the return on your investment to lower your monthly mortgage payment and increase your rental income or allow you to buy additional property. While this could be a great tool, there are rules and guidelines for cash-out refinances on rental properties:

  • The maximum loan-to-value is 75% for 1-unit properties and 70% for 2- to 4-unit properties. These maximums are lowered by 10% for adjustable-rate mortgages. If listed for sale in the last 6 months the maximum LTV is 70%.
  • The property can’t be listed for sale when applying.
  • The property is not eligible if purchased with the last 6 months unless the new loan amount is no more than the original purchase price plus closing costs, no mortgage financing was used for the purchase, the seller didn’t have a pre-existing relationship or financial interest and the buyer has a final Closing Disclosure that shows the purchase price and other transaction details.
  • These requirements all fall under the delayed financing rule.

Are There Additional Costs With a Cash-Out refinance?

Just as with a traditional cash-out refinance, you will pay closing costs. These costs are typically 2%-6% of the mortgage. For context, this will range from $5,000 to $15,000 on a $250,000 mortgage.

If you are looking to borrow more than 80% of your home’s value, you will also have to pay private mortgage insurance (PMI). This insurance typically costs anywhere from 0.55% to 2.25%. For context, PMI of 1% on a $250,000 mortgage would cost $2,500 per year.

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