If you’re considering a cash out refinance on your home, you need to know some important things to fully understand what you’re signing up for. Let’s go over the following: how does a cash out refinance work, and how is it different from a HELOC? Plus we'll discuss the pros and cons of a cash out refinance.
What is a cash out refinance?
What is a cash out refinance anyway and how does it help you? Well, it lets homeowners accomplish two things. you can:
- Refinance your mortgage (replacing your existing mortgage with a new one, often from a different lender.)
- Trade some of your existing home equity for cash you can use immediately (The amount of your equity cash-out is added to your new mortgage to be repaid over time.)
Essentially, when you opt for a cash out refinance, you are giving yourself a bigger mortgage. This could mean an increased timeframe or higher monthly payments in exchange for quick cash. Think of it as if you're undoing some of your past mortgage payments. Obviously, this financial decision has some long-term effects.
You get the money back in your wallet. But you'll also sacrifice equity and take a step back in your overall mortgage repayment progress.
That said, how does a cash out refinance work in the real world? As an example, let's say your home is worth $250,000, and you still owe $100,000 on the principal mortgage balance. So you have 60% equity ($150,000).
With a cash out refinance, you could cash out 20% of your home's equity of $150,000 to get $50,000 in a lump sum payment. This changes the mortgage amount you owe to $150,000 and drops your home equity to 40% ($100,000).
It is however important to keep in mind that many lenders won't let you drop below 20% equity in a cash out refinance.
Different types of cash-out refinancing
Now you know the answer to the question, "what is a cash out refinance?". Next, let's talk about the different types of cash-out refinancing.
While particular terms of any refinance will depend on the lenders you're working with, there are two main types of cash-out refinancing. You should be aware of both:
Standard cash out refinance
This is the most common type of cash-out refinance. It allows you to use your cashed-out funds for any reason. This attractive option can be used for home repairs, paying for education, and more.
Limited cash out refinance
This type of refinancing is much more restrictive of how much you can withdraw and what the money can be used for. Usually, the money taken out is used to roll the actual costs of refinancing into a new mortgage, such as closing costs, so you don't have to pay them out of pocket.
If you end up with any actual cash in hand, it won't be more than $2,000. The perk is that you aren't giving up equity with a limited cash out refinance.
Veterans Affairs (VA) cash-out refinance
The VA cash out refinance is a bit different than regular cash out refinances. Veterans that are eligible may get up to 100% of the home's value in cash. If you think you'll qualify based on the guidelines from the Department of Veterans Affairs and are determined to do a refi, it's worth looking into.
How is a cash out refinance different from a HELOC or home equity loan?
A home Equity Line of Credit (HELOC) is a line of credit that uses your home’s equity as collateral to guarantee repayment. You borrow what you need and make payments on the HELOC credit line.
A home equity loan on the other hand is essentially a new loan. Unlike a HELOC which is a line of credit (like a credit card), a home equity loan is tied to monthly payments based on the amount borrowed.
For both the HELOC or home equity loan, if you miss payments you risk losing your home, just like you would if you missed mortgage payments.
People may take out these loan types for home improvements, renovations, or to pay off debt. Some may even use it to get rid of PMI (Private Mortgage Insurance) on their mortgage. But it isn't the same as a cash out refinance.
Key differences between a HELOC, home equity loan, and a cash out refinance
One key difference is that a HELOC is not a type of mortgage itself and does not affect your existing mortgage. It's a totally separate line of credit that you can draw on as needed, like a credit card.
A home equity loan is established as a second loan that you will need to make monthly payments on based on your total loan amount. However and by contrast, a cash out refinance replaces your existing mortgage and increases the loan amount.
If you have a mortgage and a HELOC or home equity loan, you’ll need to make payments to both of them since they're separate loans. With a cash out refinance, it’s all combined into one new mortgage loan. The associated costs differ as well.
When you refinance your home (whether it's a cash out refinance or a regular one), you have to pay new closing costs just like when you originally bought your home.
Refinancing costs can amount to 2-5% of your mortgage principal when you factor in appraisals, inspections, applications, and more.
Fees involved in a HELOC or home equity loan also vary but can include application, appraisal, title search, lawyer costs, annual membership fees, inactivity fees, and others.
When to choose a HELOC or home equity loan
While there can be other reasons and benefits involved in home refinancing (which I'll touch on below), the only thing a HELOC or home equity loan does is make cash available to you.
However, that can be beneficial if you only need a small amount. And that amount doesn't justify a whole refinance (and you're unable to get the funds another way).
What are the pros of a cash-out refinance?
Here are some of the pros of doing a cash out refinance:
Access to liquid cash
The top reason to do a cash out refinance is that you get liquid cash relatively quickly that you could use for important things. Things like high-interest debt payoff, necessary home repairs, etc. may be easier with a cash out refi. And there are a few other benefits.
Negotiate more favorable loan terms
Like with any mortgage refinance, the other benefit is that you might be able to negotiate more favorable loan terms. Specifically, you'll want to shoot for a lower interest rate on the mortgage loan. Ideally, the interest you save over the life of the loan should outweigh the refinancing costs, so you're coming out ahead in the end.
Reduce mortgage payments or shorten loan term
People also often refinance in order to reduce their mortgage payments or shorten their loan terms. An example would be trading a 30-year loan for a 15 year. However, it's unlikely you can do either of these with a cash out refinance since you're adding to your loan.
What are the cons of a cash-out refinance?
I've already touched on some of the disadvantages, but they're worth thinking about long and hard before diving into this type of refi.
Time to pay off your mortgage is extended
The first, of course, is that since you’re giving up equity and adding extra to your mortgage loan, you’re extending how long it will take to pay off your house.
Higher monthly mortgage payments
You may also have a higher monthly mortgage payment than you're used to, which cuts into the amount of money you're able to save or invest.
More interest paid over the life of the loan
Next, even if you refinance for a lower annual interest rate, you’ll likely pay more total interest over the life of the loan. This is because the payments will probably be larger and the term longer, which means more time for interest to add up. All of this interest can set you back financially, just like the mortgage might.
Closing costs associated with refinancing a mortgage
As we've already covered, you pay various closing costs when you refinance a mortgage that can amount to thousands of dollars. You might pay this out of pocket or use some of your cash-out amount to cover it. Either way, it's another expense that may not be necessary.
Prep work for a cash out refinance
If you decide that a cash out refinance is the right choice for you, there are some requirements to keep in mind.
Equity in your home
Generally, you're going to need to have at least 20% equity in your home. So be sure to assess the market value of your home and available equity.
A good enough credit score
You'll also need a credit score of 620 or higher. In addition, you'll need your debt to income ratio to be at a certain level.
You may need to meet more requirements depending on your lender. And so it's important to understand what they are before you commit. A cash out refinance is a very long term solution, so consider why you're doing it.
If you need the cash soon for something non-negotiable, look into other options like loans or even working more hours before you consider a cash out refi - do your homework before deciding.
The best cash out refinance calculators
So, how does a cash out refinance work with the numbers for your mortgage? There are some easy ways to figure it out. Check out our favorite cash out refinance calculators.
Lending Tree has a straightforward calculator that uses charts to help explain the refinance. It uses a simple calculator at the top of the page where you can add your information. You'll then find out what your monthly costs would be.
Cash Out Mortgage Refinancing Calculator
Mortgagecalculator.org offers a very detailed calculator to help with specifics of doing a cash out mortgage. The questions are divided into sections and you can add amounts. It also shows rates and gives you an amortization schedule.
Discover offers a simple and straightforward cash out refinance calculator with just a few questions. This one is probably the least detailed, but it can be helpful if you need a fast answer. Especially if you're just starting to consider the refi.
When should you consider a cash out refinance?
Unless you’re in a very dire position, you should be extremely cautious about choosing a cash out refinance. Maybe you need money for a home repair that really can’t wait, or you have a medical emergency that can’t be negotiated.
Or perhaps you’re drowning in credit card debt and would rather have extra mortgage debt at a lower rate instead of the high interest on credit card debt.
These could all be valid reasons, but make sure to explore all your other options before choosing a cash out refinance.
Things to think about
Think about how long it took you to earn the equity you have in your home. You don’t want to give that up for a reason you don’t really need, such as a home renovation or a new patio or swimming pool. Before you decide, try writing down your reasons and sharing them with someone you trust who can see the situation objectively.
Before getting one, also carefully consider how it will affect your short-term and long-term plans. Would a higher monthly mortgage payment fit into your budget? Will having a longer mortgage term make it difficult to pay off your house by the year you want (e.g. retirement)?
Crunch all the numbers and make a solid plan that considers both your current circumstances and your future. For example, maybe you feel like you really need the money today, but will you still think that in a year or five? Know what's best for you in the long run.
Commonly asked questions about cash out refinances
There are some other important things to note about cash out refinances. Some are perks, others are just things to be aware of. Before deciding, research as much as possible.
Will you pay taxes?
There's some good news with this; a cash out refinance isn't taxable, because it isn't income. Deductions may be possible if you use the loan for some home improvements. Even if you plan on doing your own taxes, check with a tax professional about this.
What are the fees you may pay?
You will need to be prepared to pay closing costs when you do this. It's not just you getting cash, you also have to pay some fees with this deal. It's best to consider this before you choose a refinance.
What credit score do you need?
The minimum credit score that's usually needed for this is at least 620. If your credit score isn't high enough, consider alternatives. Or if you plan on doing a refi but you have some time, work on boosting your score.
Does getting a better refinance interest rate mean you'll pay less?
Consider what interest rate you're likely to get before you decide to do a cash out refinance. You might get a better rate than you had originally, but remember this doesn't mean you'll pay less because it takes more time to pay off. Still, you should definitely work hard to get a better rate than the original, to save as much as you can.
Is the foreclosure risk increased?
When you consider a cash out refinance, you're exchanging one loan for another. This likely means you'll be paying off your house for a longer period of time, which means an increased risk of foreclosure. This is simply because there's always a risk when you have any type of loan, and a longer length of time means more chances that it could happen.
Other options to get the cash you need
Now you've answered the question, "what is a cash out refinance?" Since it’s best to save options like a cash out refinance for a last resort, how else could you get the money you need? Be creative here and consider some other solutions for any money troubles.
If it's something that can wait, your best option is to hold out and save up as much as you can. Especially if your current mortgage balance is low. After all, if your home will be paid off in a few years, it does not make mathematical sense to start it over.
But if you're in an emergency, that might be less viable. When money troubles become overwhelming, it can be tough to think logically. Use a cash out refinance calculator to help you decide if it's worth it, and take your time reaching a decision.
Think carefully before choosing a cash out refinance
A cash out refinance can be a big change in your life for many years. There may not be a perfect quick-fix solution, but visit our articles on increasing your income, getting through financial hardship, starting a successful side hustle, and earning money quickly.
If you still need to consider a cash out refinance, you can be confident that you did the best you could in trying other ideas first.