How to Use Your Mortgage Cash-Out Refinance
Posted April 11, 2018 3:31 p.m. EDT
If you need money to pay for a big expense — such as college tuition, making home improvements or paying off credit card debt — and if you don’t have the savings to handle it, a cash-out refinance could help.
A cash-out refinance allows you to borrow from the equity you’ve built in your home, often at lower interest rate than other loans, and receive cash that can be used for just about any purpose. It can be a relatively cheap way to borrow money for important expenses.
But there are some risks involved with cash-out refinancing, and in certain situations, the cost will be higher than the alternatives.
This article explains what cash-out refinancing is, and dives into the pros and cons so that you can make the right decision for your needs.
What is cash-out refinancing?
A cash-out refinance involves taking out a new loan that is larger than your existing mortgage so that you can replace your old mortgage and walk away with extra cash that you can use for other financial goals.
For example, if you currently have a $150,000 mortgage on a home that’s worth $250,000, you could potentially refinance into a $180,000 loan that replaces your old mortgage and provides $30,000 that can be used for any purpose.
This is different than a traditional rate and term refinance in which your new loan balance is the same as your old loan balance.
With a traditional refinance, the primary goal is usually to reduce your interest rate and/or reduce your loan term in order to save money and potentially pay off your mortgage sooner.
With a cash-out refinance, the goal is generally both to improve the terms of your existing mortgage and tap into your home equity to help fund other financial goals.
Michael Dinich CRPS, a financial planner and the founder of Your Money Geek, says that a cash-out refinance can be an attractive way to pay for things like home improvements — in which case the interest would likely be tax deductible since the loan would be used to substantially improve the homes — or even pay off higher-interest debt like credit cards. The interest rate on cash-out refinances is usually lower than other forms of debt, such as personal loans or credit cards, because you are using collateral to back the loan (your home).
But there are some things to watch out for as well.
First, a cash-out refinance turns an asset — your home equity — into debt, which is always a decision that should be made carefully.
Second, the cash proceeds are typically first used to pay closing costs and other upfront expenses like property taxes and homeowners insurance, so you won’t always receive the full difference between your new loan amount and your old loan amount. You can apply for a no-cost refinance, but that just means that you’ll receive a higher interest rate or the closing costs will be added to the loan, so there’s really no escaping the cost.
Third, a larger loan could increase your monthly payment, and even if it doesn’t, you may end up paying more interest over the life of your loan if you are extending your loan term.
LendingTree, the parent company of MagnifyMoney, has a slew of tools to help you do the math. You can use this cash-out refinance calculator to estimate your monthly payment and this loan payment calculator to estimate your total interest cost.
So how do you decide whether a cash-out refinance is the right move for you? Let’s first look at how you can qualify and then look at situations in which it may or may not make sense.
How do you qualify for a cash-out refinance?
There are a few criteria you’ll have to meet in order to be eligible for a cash-out refinance.
You must have a credit score of at least 620 in order to qualify for a cash-out refinance on your primary home. There are several ways to check your credit score for free, and you can use these six steps to improve your score if it isn’t yet where it needs to be.
The maximum allowable loan-to-value ratio for a cash-out refinance is 80%, meaning that your total outstanding home loan balance after the refinance is complete can’t exceed 80% of the value of your home.
As an example, if your home is currently valued at $250,000, your new loan — combined with all other house related debt such as a home equity loan or HELOC — can’t exceed $200,000. If your outstanding debt is already greater than $200,000, you won’t be eligible for a cash-out refinance.
If you are looking to refinance a second home or an investment property, the maximum allowable loan-to-value ratio is lowered to 75%.
If you have a VA loan, you may be able to secure a cash-out refinance even if you don’t meet those loan-to-value requirements, but your maximum loan amount is capped depending on where you live and the type of property you are refinancing.
Your debt-to-income ratio is the sum of all your monthly debt payments — including student loans, credit cards, and auto loans, in addition to your mortgage payments — divided by your gross monthly income. It must be 50% or less in order to qualify for a cash-out refinance.
You will have to provide documentation that verifies your income and assets and proves that you are able to afford the loan. This documentation will vary by lender but often includes at least the following:
- Your two most recent tax returns
- Your two most recent W-2s
- Bank statements for the past two months
- Investment statements for the past quarter
- Pay stubs from the most recent month
How those factors affect the cost of a cash-out refinance
While meeting the minimum requirements should allow you to qualify for a cash-out refinance, you can save money by improving these variables.
Specifically, lenders may collect a surcharge that varies based on your credit score and loan-to-value ratio.
If your credit score is 680 or above and your loan-to-value ratio is 60% or less, you can avoid the surcharge. But if your credit score dips below that threshold or your loan-to-value rises above it, your fee will range from 0.25%-3% the value of your loan.
For example, let’s say that your home is worth $250,000, your current mortgage balance is $150,000, and you’d like a cash-out refinance for $200,000 — an 80% loan-to-value ratio — so that you have $50,000 available for other goals.
If your credit score is between 700 and 739, you’ll face a 0.750% surcharge that equates to $1,500.
But if your credit score is just a little bit lower at 680-699, you’ll face a 1.375% surcharge that equates to $2,750. That’s an extra $1,250 for potentially just a few points difference in credit score.
All of which is to say that getting yourself in peak financial condition will help you qualify for a cash-out refinance and make it less costly.
Good ways to use your cash-out refinancing
There are many different ways you can use your cash-out refinance, some of which could help you improve your financial situation, save you money and even increase the value of your home.
Here are a few good ways to use your cash-out refinance.
Certain home improvements, such as replacing your entry door or upgrading your kitchen, can increase the value of your home in addition to making it a more enjoyable living space. And if you don’t have the savings to pay for it outright, using a cash-out refinance to fund those improvements can be a smart move.
“It may make sense to tap home equity for home improvements because the interest rate is lower than other forms of borrowing”, said Dinich.
Another benefit of using a cash-out refinance to improve your home is that the interest should be deductible. Under the Tax Cuts and Jobs Act, only interest on home loans used to buy, build or substantially improve your deductible, and home improvements should fit the definition.
It’s worth noting though that not all home improvements will increase the value of your home. Pools often don’t represent a good return on investment, and you also need to be careful about upgrading your home too far above the rest of your neighborhood.
This is one area where it pays to do your research. A good decision can pay off, but an uninformed decision may cost you money.
Paying off high-interest debt
Because the loan is secured by your home, and because it’s considered a first mortgage, a cash-out refinance typically has lower interest rates than other forms of debt.
This not only makes cash-out refinancing an attractive option compared with other loans, but it can make it a good way to pay off other loans and save some money in the long-term.
If you have credit card debt or private student loan debt with high interest rates, for example, you may be able to reduce your rate by executing a cash-out refinance, pay off those other loans and reduce your interest charges going forward.
Proceed carefully when it comes to federal student loans though. Those loans have a number of protections — such as income-driven repayment, forgiveness and deferment and forbearance — that would be lost by refinancing. Those protections are often worth more than a lower interest rate.
It’s also worth noting that the interest charged on the portion of the new loan used to pay off debt would not be deductible since that part of the loan wouldn’t be used to buy, build or substantially improve your home.
Paying for college
With college costs on the rise, parents are forced to get creative when the tuition bills come due.
A cash-out refinance may offer a lower interest rate than other types of loans, including parent PLUS federal student loans that are currently issued with a 7% interest rate.
The big downside is that you are using your house as collateral and that you will still be responsible for the loan even if your child drops out or otherwise doesn’t finish his or her education. You are also adding to your personal debt load at a time when you may need to be ramping up retirement savings.
In many cases it will make more sense for your child to take out federal student loans. They offer more protections, and he or she will have decades to pay it off.
Still, this can be an effective strategy in the right situations.
Purchasing an investment property
Using your cash-out refinance to purchase a rental property could serve as an effective long-term investment. The cash flow produced by the rental income could both offset the costs of the refinance and serve as a helpful source of income, and purchasing the property with the proceeds from a cash-out refinance may be cheaper than other forms of borrowing.
“It’s generally less expensive for homeowners to borrow against their primary residence than to borrow for an investment property,” said Dan Green, the founder of Growella and branch manager for Waterstone Mortgage in Cincinnati. “A cash-out refinance on the primary residence can reduce the total interest costs against both properties.”
Risks associated with a cash-out refinance
While a cash-out refinance can be a smart move in the right circumstances, there are some risks as well and in some situations there could be severe financial consequences.
Here are some of the riskier ways to use a cash-out refinance.
While using a cash-out refinance to pay off high interest can look like a no-brainer on the surface, there are some significant risks to be aware of.
“Accessing home equity to pay off high-interest credit card debt can be a good strategy, but only when it is in conjunction with the creation of a sustainable spending plan”, said Justin Harvey, a fee-only financial planner and the founder of Quantifi Planning, LLC in Philadelphia.
That is, taking out new debt to pay off old debt is generally only effective if you have a strong budget in place and a sustainable plan to both repay and stay out of debt. If replacing your credit card debt simply frees up space to reload those same credit cards, you could be doing more harm than good.
“Some of the consumers who were most harmed by the 2008 economic collapse were homeowners who treated their primary residence like an ATM during the housing price run-up,’ said Harvey. “When the price correction followed, many were stuck with a high-dollar mortgage on a low-value asset, and some homeowners were even underwater.”
Investing in the stock market
Taking out a loan to invest in the stock market is rarely a good idea. Stock market returns are not guaranteed, especially in the short term, and it’s possible to lose a lot of money in a short period of time.
If your investments do lose value, you may not have the money needed to make your mortgage payments, in which case you could be at risk of foreclosure.
Buying a car
“Taking out money to buy a car might not be a good way to use your equity,” said Jeremy Schachter, branch manager at Pinnacle Capital Mortgage in Phoenix. “You take out that equity and roll the interest over a 30-year period or take maybe a higher interest rate auto loan at a shorter term.”
Interest rates on auto loans are often low, especially if you are buying a new car and/or have excellent credit. And the loan term is typically one to eight years, which is shorter than most home loans and therefore often leads to lower interest costs over the life of the loan even if your interest rate is higher.
Starting a business
Only about half of all new businesses survive five years or longer, and only a third make it to 10 years or more. That’s less than the length of a typical mortgage, which means that you could run into trouble making your loan payments and put your house at risk in the process.
“Not all business loans are secured loans and all mortgage loans are,” said Green. “When your business succeeds, the distinction is less relevant. But when your business fails, having an unsecured loan is an advantage.”
If you do need a loan for your business, here are some alternatives to consider: 17 Options for Small Business Loans.
Lending money to friends and family
Lending money to friends and family is always risky because if the deal goes south, your personal relationship could be in jeopardy.
Financing that loan by taking on new debt yourself adds to the cost and risk of the transaction. And by tying that debt to your house through a cash-out refinance, you’re putting yourself in a position where if your friend or family member can’t pay you back, you could end up losing your home.
Put simply, this is rarely a good idea. If you’re determined to do it though, Green says that you should approach it like you would any other business decision.
“If you’re lending to friends or family members,” Green said, “you should use the same due diligence as with any investment and charge an appropriate interest rate for the risk.”
Should you use a cash-out refinance?
A cash-out refinance often has a lower interest rate than other types of loans because it’s secured by your home and because it’s considered a first mortgage. That can make it an attractive way to pay for big expenses, especially if you can reduce the interest rate on your existing mortgage in the process.
But that debt comes at a cost and it’s always worth evaluating all of your options, from saving the money you need yourself to exploring other types of loans.
In the end, a cash-out refinance is just one tool of many. When it’s used thoughtfully, it can provide a good return on investment. When it’s not, it can be just another costly debt.