If you want to access the equity in your home without a second mortgage, a cash-out refinance may be the solution. In the right circumstances, you may be able to lower the interest rate on your mortgage and take advantage of your available equity without significantly increasing your monthly payments or financial risk.
What is a cash-out refinance?
A cash-out refinance is a “first-lien” mortgage because you take out a new mortgage that replaces your existing one. Like a traditional mortgage refinance, the funds from the new loan are used to pay off the original.
However, in this case, instead of taking out a new loan equal to your current mortgage balance, you take out a larger loan based on the equity you have available in the home. Once the existing mortgage is paid, you receive the difference as a lump sum of cash. Thus, you “cash-out” a portion of your home’s equity.
With a full cash-out refinance, you can generally borrow up to 80-90% of the available equity in your home. This varies by lender. Some lenders will let you cash out more, some will be more conservative.
Due to economic uncertainty caused by the COVID-19 crisis, many lenders have restricted cash-out refinancing and other equity borrowing options. In the current situation, you may be able to tap into a lower percentage of your available equity.How does cash-out refinancing work?
Step 1: Decide how much equity you want to cash out
First, you should determine exactly how much equity you want to cash out. Just because you may find a lender that’s willing to give you up to 90% of the equity you have available, doesn’t mean you should take that much. Only take out the equity that you need and leave the rest to build value.
An example of how to determine your available equity
Lenders determine the equity you can borrow based on your current loan-to-value ratio (CLTV) and the remaining balance on your mortgage.
Let’s say your home is worth $250,000 and a lender allows you to borrow up to 90%. You owe $150,000 on your mortgage. Here’s how you’d calculate the equity you have available:
(Max CLTV) x (Value of your home) = (CLTV value)
0.9 x $250,000 = $225,000
(CLTV value) – (Current mortgage balance) = (How much equity you can cash out)
$225,000 – $150,000 = $75,000
This means you have $75,000 available that you can potentially borrow. Now you can determine the funds you need and plan the cash out refinance accordingly. Remember, there’s nothing wrong with leaving equity on the table in the refi!
In fact, that will make you more financially stable moving forward. And keep in mind that if you borrow up to 90% CLTV, you may be required to pay for private mortgage insurance (PMI) on the new loan. Lenders require PMI for any CLTV higher than 80%. This is something else to consider as you decide how much to borrow.
Step 2: Find the right lender
Your next step is finding the right lender with the right rates and terms to refinance your home. There is nothing that requires you to use the same lender as you had with your original mortgage.
Since you are shopping around for a new mortgage, you can take advantage of rate shopping without hurting your credit. You can authorize credit checks with a range of lenders within a 14-45-day period. These inquiries will be grouped into a single inquiry because the credit bureaus will treat it as you shop around for a single mortgage product.
This allows you to see rates and terms from multiple lenders to find the best loan for your needs. The right lender is the one that offers the lowest rate at the CLTV you need to get the amount of equity you want. But be careful, if the rates is too good to be true, it may be a predatory lender.
Step 3: Get approved for the loan and get an appraisal
Next, you will go through the loan underwriting process to finalize the loan. This is where you’ll work with a loan underwriter to provide all the documentation required to verify your identity, address, and income.
The lender will also help you arrange a property appraisal, which will confirm the current market value of your home. Until the appraisal is done, everything is an estimate based on property data. However, the appraisal confirms the value of the home to cement how much money you’ll eventually get.
A full appraisal can be costly (up to $300-$400 for a single-family home).[1] However, many lenders do not require an on-site appraisal for refinancing. Particularly with new COVID-19 concerns, many appraisals are being done virtually, using tools like Automated Valuation Models (AVMs).Once the value of the home is confirmed, you’ll finalize the terms of the loan. You’ll know the monthly payments you’ll be paying, when the loan will begin and get a closing date.
Step 4: Get to closing and receive your funds
After the appraisal is done, you should get a closing date from the lender. This should take about two weeks.[2] At the closing, you will receive the closing disclosure that reviews the terms of your loan. You’ll sign the paperwork to complete your closing.
As with your original mortgage, closing costs will be included in your new loan. These costs usually total up to 3-5% of the purchase price of the home.[3]
You will not receive your funds on the closing day. The Truth in Lending Act gives homeowners something known as the right of rescission. This gives homeowners the right to cancel any home equity lending option within three days of closing.
However, this also means you don’t receive the funds immediately. So, you generally will receive the funds to your account three days after closing.[4]
Weighing the pros and cons
The pros
Lower interest can help you save
Since this loan is a first mortgage instead of a second, it offers lower interest rates than home equity loans and HELOCs. First mortgages have some of the lowest rates possible on consumer financing, so it’s a cost-effective way to get cash.
Even better, if you refinance at the right time, you can lower the interest rate compared to your original mortgage. This way, you save money as you pay off your home.
Deductions help you save even more
Mortgage interest is often tax-deductible, meaning you can lower your tax liability each year by deducting the interest you’ve paid. If you’re using part of the money you cash out to pay off other debts, you get a tax break in addition to lower APR. No other debt offers this kind of interest deduction.
You know what to expect with your budget
With a mortgage, you know what to expect. You enjoy fixed monthly payments because it’s an installment loan. This offers advantages over financing like HELOCs, where the payments increase significantly after the 10-year draw period.
Give your credit a boost by paying off revolving debt
If you use the equity you receive to pay off things like credit card debt, you will decrease your credit utilization ratio. This measures the amount of credit card debt you have relative to your total limit. Paying off debt with equity may lead to a credit score boost. The trick is not to run up new balances!
The cons
You’re back to a higher mortgage balances
Unlike basic refinancing where your balance remains the same, a cash-out refinance modifies your mortgage. The principal is higher because it includes the equity you cashed out. So you have more mortgage debt to pay off.
If you are nearing retirement, this can put you at a disadvantage. Owning your home free and clear as you retire gives you more security.
Factor costs into your decision to borrow
Refinancing is not cheap. Closing costs amount to 2-5% of the new mortgage. If you get a $200,000 mortgage, the costs may total up from $4,000 to $10,000. Make sure that the equity you’re taking out AND the interest rate savings you may get are worth that cost.
Your lender may need extra protection, depending on how much you borrow
If you borrow up to 90% of your equity (or anything over 80%) then you will need to pay private mortgage insurance (PMI). The lender will require this until you make enough payments to reach 80% CLTV.
Cash-out refinancing for FHA and VA loans
FHA cash-out refinance
If you have an FHA mortgage, backed through the Federal Housing Administration, then you can get a new FHA mortgage that offers cash-out financing if you have equity available.
The challenging part is usually having the equity built up that you need. You can qualify for an FHA loan with as little as 3.5% down. However, that means that you start with a 96.5% loan-to-value ratio.
You must have an 80% LTV before you will qualify to use cash-out refinancing. It can take years of making payments before you get to that point. And you need more equity than that because the FHA limits cash-outs to 80% of the home’s available equity.
You must also live in the home as your primary residence, be named on the title, and have made on-time mortgage payments for the past 12 months.
VA cash-out refinance loan
Veterans and Service Members have access to cash-out refinancing through VA-backed home loans. A VA cash-out refinance loan allows you to tap into equity for a variety of purposes. Your current loan does not need to be a VA loan to qualify. You can have a non-VA mortgage and convert it into a VA loan as you refinance.
Comparing a cash-out refi to other options
Cash-out refinancing is not the only way to tap into the equity in your home. You also have home equity loans and home equity lines of credit (HELOCs).
However, these options are second mortgages. Unlike a cash-out refinance, you are not taking out a new loan that replaces your existing one. Instead, you take out a second lien against your property in addition to your existing loan.
This means that with a home equity loan or HELOC you generally have a second payment and term that’s separate from your mortgage. This can create a higher risk of foreclosure because you have two payments to cover and two liens against your property.
On the other hand, home equity loans and HELOC often have lower costs, because you do not go through closing again.
All these options can be beneficial in specific financial circumstances as a homeowner. Deciding which one (if any) is right for you depends on several factors, including:
- How long you plan to stay in the home
- How much equity you want to borrow
- Whether you need a lump sum or open line of credit
You should always consult with a mortgage expert before deciding to tap your equity. You may also consider an evaluation from a HUD-certified housing counselor. Housing counselors work for nonprofit organizations and have a responsibility to provide advice that’s in your best interest. This way, you know you’re getting an unbiased opinion on the best option to use given your specific financial situation.
Non-equity alternatives
If you don’t have equity to borrow against or you’re concerned about the increased risk of foreclosure, there are other options you can consider.
The most popular option is an unsecured personal loan. You can use a personal loan for the same range of purposes that you can use a cash-out refinance, from debt consolidation to financing big projects.
In some cases, it may make sense to borrow against equity, particularly for home improvement projects. Again, talk to a lender to understand your options and consider the benefits and risks of each loan based on your situation.
Other options for debt relief
If you are considering using some or all the funds from cash-out refinance to pay off other existing debts, there are some important things to keep in mind.
The most important thing is that borrowing against equity can be extremely risky if you are not financially stable. If you find yourself in a pattern of borrowing and consolidation and taking on more debt to solve your existing debt, this not the time to borrow against your home. The cycle may continue, which could put you at risk of foreclosure.
Consider these options that don’t rely on new financing instead:
- Debt management plans repay everything you owe more efficiently by minimizing interest charges, so you avoid credit damage. Instead of taking out a new loan, you set up a repayment plan through a credit counseling
- Debt settlement programs allow you to get out of debt for a portion of what you owe. It’s ideal if your debts are in collections or you’re slowly falling behind. Debt settlement does cause some credit damage but is often the fastest way out of debt without declaring bankruptcy.
- Bankruptcy is often avoided because of the social stigma, but it can be a good way to get a clean break from debt. Despite what you may have heard, you can even use it to discharge debts that can be problematic to get rid of, like student loans. If you just need a fresh start, bankruptcy may be the best option.
Talk to a certified expert to discuss your options for debt relief before you borrow against your equity.
FAQ
No. Since a cash-out refinance is a first mortgage instead of a second mortgage, it has lower rates. You will enjoy the same low rates you had on your existing mortgage. If you refinance at the right time, you can take advantage of some of the lowest consumer borrowing rates possible.
Comparatively, home equity loans and HELOCs have higher rates than cash-out refinancing. Unsecured lending options, such as personal loans and credit cards tend to have much higher rates.
Since cash-out financing means that you go through closing again, it generally takes longer than borrowing options like home equity loans and HELOCs.
It generally takes about 40-45 days to get to closing, then you must wait three days for the right of rescission period to pass. Once this time passes and the lender knows you do not want to cancel, you will receive your funds.
A limited cash-out refinance is not intended to give you a large sum of equity. You receive no more than 2% of the new loan or $2,000 – whichever is less. This small sum is often be used to cover the closing costs or pay “points” off the mortgage to get a lower rate.[5]
Sources:
[2] https://themortgagereports.com/19487/how-long-does-it-take-to-close-a-mortgage-gina-pogol
[3] https://www.zillow.com/mortgage-learning/closing-costs/
[4] https://www.investopedia.com/terms/r/right_of_rescission.asp
[5] https://mortgage.info/meet-another-refi-option-limited-cash-out-refinance/
