December 30, 2021
If you’ve built equity in your home, you may have the opportunity to use a cash-out refinance. This type of refinance gives you access to the equity or the difference between your home’s value and your outstanding mortgage balance.
It takes time to build equity in your home, but you have equity once you owe less than the home’s value. If you made a sizeable down payment, your home appreciated, or you’ve made extra payments toward your mortgage through the years, chances are you have home equity, and you can tap into it.
But is it a smart financial move?
Here’s everything you must know about the cash-out refinance to help you decide.
Cash-Out vs. No Cash-Out
If you have a mortgage on your house now, it’s essential to understand the difference between a cash-out and no cash-out refinance.
A cash-out refinance, like we said above, taps into your home’s equity. You get access to up to 80% of the home’s value minus any outstanding mortgage balances. For example, if your home is worth $300,000, you can have a loan for a total of $240,000.
Any first mortgage balance you have will lower the amount accordingly. If you have a $100,000 first mortgage balance, for example, you could borrow an additional $140,000 to reach $240,000.
A no cash-out refinance doesn’t tap into your home’s equity. Current homeowners with a mortgage use it to secure a lower rate, change the loan’s term, or refinance from an Adjustable Rate Mortgage (ARM) to a fixed-rate loan.
You don’t receive cash in hand, but you may benefit financially in other ways, such as saving money on your monthly payment or over the life of the loan. Borrowers often use this when interest rates drop, their income increases, and they can afford a shorter term, or they need help lowering their payment to make it more affordable.
What Can You Use a Cash-Out Refinance For?
The good news is there aren’t any rules specifying how you must use your cash-out funds. But there’s one exception. If you have a high debt-to-income (DTI) ratio and use the funds to consolidate debt, some of the funds may be required to pay the debts off and get your DTI down.
If you are using the funds for anything but debt consolidation, you are free to use them how you want. Here are some common ways borrowers use their home equity funds:
- Home renovations or repairs can get expensive to fix up your home or renovate it. Using credit cards can get costly because of the higher interest rates, and personal loans may not be enough to cover the cost. Your home equity funds are an excellent use for home renovations. That’s because you use the funds to reinvest in your home.
- Emergency fund – After the year we had, you likely realize the importance of having an emergency fund. If you went through yours during the pandemic or never had one, taking the equity out of your home can be a smart move to set you up financially.
- Paying for college – If you’re covering your children’s educational expenses and they don’t receive enough in federal student aid, you can tap into your home’s equity to make up the difference without paying high-interest rates or putting your child in debt.
- Vacations, weddings, or any other expense – You can use your home equity funds for just about any purpose. Many borrowers use them for a family vacation, wedding, or high additional costs they come across that they can’t pay for in cash.
There aren’t any rules as to how you must use them, and you typically don’t have to get the reason ‘approved’ before you can close on it.
It’s essential to understand when you take out a cash-out refinance, you increase your mortgage amount and use your home as collateral. If you’re comfortable with the new payment, though, it can be a great use of your home’s equity. Here are the most common benefits borrowers realize:
- Interest rates are competitive and better than most other loan options
- If you use the funds for home improvements, ask your accountant about tax benefits
- It’s an affordable way to consolidate debt
- You can increase your emergency fund or pay for other financial goals at a low APR
- It’s easy to qualify if you make your mortgage payments on time and have average credit
- It’s your money to use how you want
So far, we talked about a cash-out refinance on homes with a mortgage, but it isn’t only for homeowners with a mortgage on their property. If you own your home free and clear but need some of the cash tied up in it, you can use the cash-out refinance.
Most borrowers can take out up to 80% of the home’s value. If you don’t have a mortgage on your home, that means you can receive the complete 80% in hand if needed. Something to keep in mind, though, your home is the collateral.
Make sure you only take out as much equity as you can afford to pay back. You can borrow a mortgage in many terms ranging from 10 – 30 years, but make sure the payment is affordable.
Is a cash-out refinance a smart financial move?
It depends on your situation. How are you using the funds? Can you afford the payment?
These are the questions you must ask yourself before choosing a cash-out refi. For most borrowers, it’s the best use of their home’s equity, especially if they have other long-term financial pieces in place, such as life insurance and retirement funds.
Think about the long-term effects of using the funds and decide if using your home’s equity is the right choice for you.