While a cash-out refinance has many benefits, it’s important to consider both the pros and cons of this financial product before applying for one.
A cash-out refinance lets you tap into the equity you’ve built into your home. You can use this cash for any expense, but you should know the cash-out refinance pros and cons before starting the process. The potential risks of a cash-out refinance include foreclosure, high closing costs and paying more interest over time, albeit at a lower rate.
This guide will outline how cash-out refinances work, what to consider and some alternatives.
What is a Cash-Out Refinance?
A cash-out refinance is a financial product that replaces your mortgage with a new one and provides you with the difference in cash while also allowing you to negotiate a new interest rate and/or loan term. A refinance allows you to stick with one monthly mortgage payment instead of ending up with a second mortgage, like with a home equity loan or a HELOC.
RELATED: Cash-Out Refinance vs. Home Equity Loan
A cash-out refinance starts by replacing your current mortgage with a new mortgage with a higher balance. For example, if you borrow $50,000 worth of home equity and have a $300,000 mortgage, you’ll refinance to a $350,000 mortgage.
Your interest rate will differ, and you can opt for the same term length or modify the number of years on the loan. Converting a mortgage from a 10-year to a 15-year term can result in lower monthly payments even if you borrow equity from your home. After the cash-out refinance is finalized, you can access the extra cash in your bank account. In this case, it’s an extra $50,000.
Cash-Out Refinance Pros
A cash-out refinance can be very beneficial for some homeowners. Here are some of the benefits of this refinancing type.
Access Home Equity as Cash
A cash-out refinance lets you tap into home equity for any expense. The sudden windfall can help with vacations, medical bills, home improvements or other expenses. You can access money during emergencies and preserve your savings account.
Potential for Lower Interest Rate
If your credit score is higher, you might qualify for a lower interest rate. Getting a lower rate will also be easier if the Federal Reserve decides to reverse course and initiate some rate cuts.
“It also extends your loan term,” says real estate investor Tim Gordon. This may or may not be a good thing, depending on how much time is left on your original home loan.
Fixed Interest Rate Option
You can get out of a variable-rate mortgage with a cash-out refinance. You can also choose a fixed interest rate for your new mortgage. Fixed rates result in consistent monthly payments and more predictability with budgeting. A fixed-rate mortgage will stay the same if the Federal Reserve decides to hike interest rates.
Potential Tax Deductions
You can deduct the funds you receive from a cash-out refinance if you use them for home improvements. Homeowners can also deduct mortgage interest payments to reduce their tax bills.
Consolidate High-Interest Debt
You’ll have to pay interest if you borrow money through any loan or line of credit. However, you will likely get a lower rate with a cash-out refinance than with unsecured debt like credit cards and personal loans. You can use the cash-out refinance to repay your high-interest debt so interest doesn’t compound as quickly.
May Build Credit
It’s possible to build your credit score with a cash-out refinance. You can access additional equity and reduce your monthly payments by extending your term. Then, it will be easier to make on-time payments every month. Each of those monthly mortgage payments will improve your credit score.
Cash-Out Refinance Cons
While cash-out refinances offer several advantages, they also have setbacks you should consider.
Closing Costs Involved
Cash-out refinances have high closing costs, ranging from 2% to 6% of the loan’s balance.
“Closing costs can eliminate savings since you may not be in the home long enough,” says Daniel Cabrera.
You can either pay those closing costs immediately or tack them onto your loan, accumulating more interest.
Foreclosure Risk
Any mortgage presents the risk of foreclosure if you default. However, a cash-out refinance can increase your monthly payments if you do not adjust the term’s length. Higher mortgage payments can increase the risk of falling behind on monthly payments, but you can extend your loan’s term to minimize this risk.
Increased Mortgage Balance
A cash-out refinance increases your mortgage balance, translating into higher monthly payments. That higher balance will also continue to accumulate interest, resulting in a less favorable amortization schedule.
“Extending the loan term may lower monthly payments, but it will increase the total interest paid over time,” Cabrera adds.
Longer Loan Term
A longer loan term keeps you in debt longer. One of the main advantages of homeownership is that you can eventually become debt-free and have more budget flexibility. A cash-out refinance can force you to extend the loan’s duration to preserve your budget, keeping you in debt longer.
Potential Loss of Equity
A cash-out refinance results in lost equity that you’ll have to reaccumulate with monthly mortgage payments. A higher equity position allows you to tap into more cash if necessary and get closer to becoming debt-free.
How Do You Get a Cash-Out Refinance?
If you think a cash-out refinance is right for you, here are the steps you should take to secure one:
Calculate Your Home Equity
The amount of money you can receive from a cash-out refinance will depend on how much equity you’ve built in your home. Equity equals your home’s market value minus your remaining mortgage balance. So, if your home is worth $400,000 and you have $150,000 remaining on your mortgage, you have $250,000 in equity.
Make Sure You Qualify
Every lender is going to have their own set of eligibility criteria for a cash-out refinance, but generally speaking, you’ll need the following to qualify at most banks or credit unions:
- A credit score of 620 or higher
- A debt-to-income ratio of 50% or lower
- Minimum home equity of 20%
Shop Around for Lenders
In most cases, you can return to your original mortgage lender and receive a cash-out refinance. You can also look at our expert-verified list of the best cash-out refinance lenders.
Submit the Application
Once you find a lender with rates that work for you, file an application for a cash-out refinance. You’ll need the following documents to complete the process:
- Tax returns and W-2s from the past two years
- Pay stubs from the last month
- Bank statements for the past two months
Have Your Home Appraised
Although not always required, a lender will likely have your home appraised to confirm its market value. Find out ways you can get a free home appraisal or one at a reduced cost.
Close on the Loan
Just like with your first mortgage, you’ll have to pay closing costs (equal to around 2-6% of your total loan amount) and sign a few documents before the loan is finalized.
It should then be in your account within three to five business days.
Cash-Out Refinance Alternatives
While cash-out refinances are popular financial products, there are other ways to tap into your home equity. Here are some of the alternatives.
Home Equity Loan
Home equity loans allow you to access equity as a lump sum. You must make fixed monthly payments over a 5 to 30-year term. You must fulfill credit score and income requirements to get a home equity loan. However, these requirements are similar for cash-out refinances and HELOCs.
Home Equity Line of Credit (HELOC)
Home equity lines of credit also let you receive a lump sum, but it comes as a revolving credit line with a variable interest rate. Interest payments only start when you borrow against the credit line. You only have to pay interest during the draw period, which can last 10 years. Any remaining balance gets converted into an installment loan after the draw period. The term for this new loan can be as long as 20 years.
What to Know Before Taking a Cash-Out Refinance
- A cash-out refinance lets you change the rate and/or term of your current mortgage while accessing capital via your home equity.
- You end up with a new mortgage, which can result in lower or similar monthly payments.
- While you get cash immediately, it’s important to address the habits that get you in debt in the first place.
Why You Should Trust Us
Benzinga has offered investment and mortgage advice to more than one million people. Our experts include financial professionals and homeowners, such as Anthony O’Reilly, the writer of this piece. Anthony is a former journalist who’s won awards for his New York City economy coverage. He’s navigated tricky real estate markets in New York, Northern Virginia and North Carolina.
For this story, we worked with real estate investor Daniel Cabrera, owner of Sell My House Fast SA Texas; and San Diego-based real estate investor Tim Gordon, owner of Gordon Buys Homes.
Frequently Asked Questions
What is the negative to a cash-out refinance?
The main negative of a cash-out refinance is that it comes with closing costs that can equal 2-6% of your total loan amount. Also, extending your loan term may result in lower monthly payments, but it could increase the total amount paid over time.
Do you lose your interest rate with a cash-out refinance?
Not necessarily. Some cash-out refinance lenders may let you keep your interest rate, so it’s important to check with your bank or credit union before filing an application.
Do you pay taxes on a cash-out refinance?
No, the IRS does not tax money received from a cash-out refinance because it’s a loan, and not income.
Sources
- Daniel Cabrera, owner of Sell My House Fast SA Texas
- Tim Gordon, real estate investor and owner of Gordon Buys Homes
About Anthony O'Reilly
Anthony O’Reilly is an updates editor for Benzinga. He’s won numerous journalism awards for his coverage of the New York City economy and Long Island school district budgets.