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Cash-Out Refinance: Pros and Cons

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If you need cash fast, you may be considering a cash-out refinance. Before you sign on the dotted line, it’s important to understand what you’re getting yourself into in terms of pros and cons. So here’s everything you need to know about cash-out refinances to determine whether or not this is the best solution for you: 

What Is a Cash-Out Refinance?

A cash-out refinance involves taking out a new and higher loan on your home based on its equity. This new loan is used to pay off the existing loan amount but gives you the leftover amount in cash that you can use at your discretion. Most cash-out refinances allow you to borrow up to 80% of your home’s equity. 

For instance, say you took out a $300,000 mortgage to buy your home roughly ten years ago. After ten years of mortgage payments, you now owe around $200,000 on your home. Based on your home’s equity, you’re able to take out a cash-out refinance loan for $250,000. You use the $200,000 to pay off your original mortgage while using the remaining $50,000 to cover the new kitchen or bathroom renovations you’ve been dreaming about. 

Reasons Why You May Want to Consider a Cash-Out Refinance

There are several reasons why you may want to consider a cash-out refinance, including: 

  • Home improvements: One popular thing to do with a cash-out refinance is use it to finance home improvements. This is a particularly good investment that allows you to boost your home’s resale value so long as you choose worthwhile upgrades. For instance, things like bathroom remodels, kitchen remodels, and landscaping.
  • Education expenses: Another thing you can do with a cash-out refinance is use it to cover education expenses. Education expenses are constantly rising and it can be difficult to come up with the funds to cover tuition, fees, books, etc. While education isn’t an investment in the traditional sense, it can help boost your earning potential and be a beneficial long-term investment. 
  • Medical expenses: Medical expenses can come up out of the blue and can quickly wreak financial havoc. While having insurance helps, it doesn’t cover everything and you can be left with seemingly endless bills. Instead of taking drastic action like filing for bankruptcy, you may want to consider using a cash-out refinance to cover your medical debts and avoid them going into collections that will hurt your credit. 
  • Business ventures: Finally, the last thing you can do with a cash-out refinance is to use it to finance a new business venture. Starting a business is expensive and a cash-out refinance can provide you with the seed money you need to make a successful launch. While this is definitely a risky option since there’s never a guarantee of success, it can be worthwhile if you have a great business idea that will end up making you a lot of money. 

How Does a Cash-Out Refinance Work?

Here’s what happens during the cash-out refinance process: 

  1. Choose a few potential lenders that you want to consider. 
  2. Check the requirements for each lender, including credit score, debt-to-income ratio (DTI), and equity amount. Most lenders will require a credit score above 620, a DTI less than 50%, and at least 20% equity in your home. 
  3. Determine how much cash you need from the cash-out refinance. If you’re using it for renovations, get estimates from reputable contractors. If you’re using it to pay off other debts, make sure to add them all up for a complete financial picture. 
  4. Apply through your chosen lender and provide all required documentation. 
  5. Get approved by your lender and pay any required closing costs. 
  6. Close on your new loan and get your cash in a timely manner. 

What Are the Pros of a Cash-Out Refinance?

Here are some of the pros of a cash-out refinance that you should consider:

  • Low interest rates: Cash-out refinances offer relatively low interest rates that are more favorable than many alternatives. However, it still makes sense for you to shop around for different rates from different lenders to find the best one. Even a few tenths of a percentage point can make a big difference in how much interest you’ll pay over the lifetime of the loan. 
  • Build your credit score: Using a cash-out refinance to pay off your credit cards allows you to build your credit score by reducing your credit utilization ratio. As a result, you may be able to secure more favorable terms on other loans. 
  • Debt consolidation: Using a cash-out refinance can help you consolidate your debt by paying off high-interest credit cards or other loans with a low-interest alternative that will save you a lot of money over time. 
  • Tax benefits: Cash-out refinances come with potential tax benefits like the mortgage interest deduction that can be used if you’re using the money to buy, build, or substantially improve your home. Speaking with an accountant is the best way to figure this out. 
  • High loan amounts: Cash-out refinances give you access to high loan amounts based on the equity of your home. Oftentimes, these amounts are higher than those you would otherwise qualify for. 
  • Long repayment periods: Since you’re given a new 15-year or 30-year mortgage, cash-out refinances give you more time to pay back your loan rather than only having a few years to come up with the money.

What Are the Cons of a Cash-Out Refinance?

Here are some of the cons of a cash-out refinance that you should consider: 

  • Long-term interest costs: Even though cash-out refinances boast lower interest rates than other types of loans, you’re going to increase your long-term interest costs since you’re essentially restarting your mortgage and borrowing more. 
  • Foreclosure risk: Cash-out refinances use your home as collateral in the event that you’re unable to repay the loan. If you can’t make the payments, you’re at risk of losing your home through foreclosure. 
  • Closing costs: Cash-out refinances aren’t free and instead come with closing costs. Although closing costs tend to vary, you should expect to pay somewhere around 2% to 5% of the loan. This adds up to thousands of dollars that may make this option less worthwhile. 
  • Private mortgage insurance: Cash-out refinances may leave you on the hook for additional payments in the form of private mortgage insurance. This added cost becomes required if you borrow more than 80% of your home’s value until you get back up to 20% equity. Private mortgage insurance, or PMI, can cost you anywhere between 0.55% to 2.25% of the loan amount each year. 

Potential Alternatives to a Cash-Out Refinance

Based on the aforementioned pros and cons of a cash-out refinance, it may not be the best option for you. In this case, you may want to consider some potential alternatives to a cash-out refinance: 

  • Personal loan: Personal loans are flexible and shorter-term loans that can be used for a variety of different purposes. Personal loans have terms around five years long but often come with interest rates that are higher than that of a traditional mortgage depending on your credit score. 
  • Home equity line of credit: Home equity lines of credit, or HELOCs, act as credit cards that allow you to borrow against your home equity. They are quite flexible in terms of use and repayment, making them a great option for those looking for quick and cheap cash with interest rates lower than a typical credit card.  
  • Home equity loan: Home equity loans differ from home equity lines of credit in that you’re given a lump sum of cash to use rather than funds that you can borrow at your discretion. Most home equity loans allow you to borrow up to 80% of your home’s equity so long as you have built up more than 20% equity. Home equity loans tend to come with lower closing costs in exchange for higher interest rates. 
  • Other sources of cash: If none of these alternatives work for you, then you may need to get creative to come up with other sources of cash. For instance, you can refinance other loans like auto loans or student loans for more affordable interest rates. You can restructure debt to pay it off easier and faster. You can sell valuables or unused items around the house. You can start a side hustle to earn extra cash. You can borrow from family, against your 401k, or from credit cards. 

Final Thoughts on Cash-Out Refinance

As you can see, cash-out refinances make sense in some situations but not others. If you’re considering a cash-out refinance and are looking for financial advice that is tailored to your unique situation, you may want to consider reaching out to the experts at Vaster Capital. Vaster Capital offers a wide range of financing solutions on top of professional expertise.

 

Sources:

  1. Cash Out Refinancing: Pros, Cons, & Alternatives | Debt.org
  2. Cash-Out Refinance Pros and Cons | Nerd Wallet
  3. Learn the Pros and Cons of Cash-Out Refinancing | The Balance