Thinking about tapping into your home’s equity? Familiarize yourself with how a cash-out refinance works along with its benefits.
If you’re short on cash for a big project but have a substantial amount of equity in your home, a cash-out refinance might be the solution you’ve been seeking. This option can fund your financial goals while helping you avoid high interest options, like personal loans or credit cards.
Learn more about how a cash-out refi works, consider the pros and costs, and decide whether it’s worth exploring further.
One of the many benefits of homeownership is the ability to build equity through paying down the principal balance on a mortgage or through appreciation, which is an increase in value.
For example, suppose you purchased your home for $275,000. The value of the home is now $325,000 and the principal balance on your mortgage is $200,000. This means you have $125,000 in equity due to appreciation and paying down the mortgage.
One way to access the equity in your home is through a cash-out refinance. This option allows you to receive a portion of your home’s equity in a lump sum and obtain a new loan with a larger principal balance than your current mortgage.
You’re free to use the funds as you see fit; homeowners often use the proceeds to make costly home repairs and improvements, pay off high-interest debt, contribute to a child’s college education, and fund investments. The possibilities are truly endless.
Things to Note
For most cash-out refinance mortgages, the maximum amount you can draw out is 80% of the home’s value. In the example above, that would be equivalent to $260,000; since you still owe $200,000 on the prior loan, however, that leaves $60,000 in equity available to borrow.
Interest rates can make a cash-out refinance especially attractive. They’re generally lower than similar loans, like a home equity loan or home equity line of credit. Additionally, the current rate environment, an improvement in your credit score, and/or greater financial stability can contribute to qualifying for a rate that is lower than that of your existing mortgage.
Another benefit is the ability to take advantage of the mortgage interest deduction on proceeds used to substantially improve your main home. Refer to the refinancing portion of this Home Mortgage Interest Deduction Publication from the IRS for more information.
On that note, it’s also important to understand that money drawn from a cash-out refinance isn’t considered income; therefore, you don’t need to pay taxes on it.
Most mortgages have both fees and closing costs and this one is no different. Closing costs run about 2-5% of the new loan amount and can include lender origination, appraisal, and title fees. These costs and other details will be outlined in the Closing Disclosure you receive.
As noted, a cash-out refinance results in a completely different loan with a new set of characteristics, including interest rate, term, and payment amount too. Make sure you fully understand the new mortgage’s ins and outs before finalizing anything.
Lastly, it can take a while to get from application to close. Your loan can only move as fast as the different parties can go. One area that can cause delays, for instance, is the appraisal. In addition, it’ll take a few days after closing to receive funds due to your lender being required to provide three days to cancel the loan, known as the Right of Rescission.
First things first, determine how much you’ll need to fund your project to determine if you have enough equity and to evaluate whether this option is a good fit for you.
A cash-out refinance only makes sense if the potential savings justify the cost of the new mortgage or is the best option for your situation. This can be the case with larger cash-out amounts, mortgages with an interest rate reduction, and mortgages with lower principal amounts (since closing costs are based on this).
Use tools like this refi calculator to estimate savings and speak to a loan expert for additional information or to compare loan options. A lender can talk to you about the requirements needed for the loan, such as the minimum credit score, debt-to-income ratio, financial documents needed, etc.
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