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What is a cash-out refinance and is it right for me?
Tap into your home’s equity and get some cash to pay for home renovations — which could come with tax benefits.
You can use a cash-out refinance to secure a better interest rate while withdrawing money from your home’s equity to cover large expenses. Many homeowners use cash-out refinances for home improvements, to help pay for a child’s college tuition and to consolidate higher-interest debts. But cash-out refinances may not always make sense.
What is a cash-out refinance?
A cash-out refinance uses your equity for a new mortgage that’s more than what you owe. You get the difference between your old and new loans in cash to use however you want. The new mortgage may have a lower interest rate or a different loan term than your original home loan.
Cash-out refinances are different from a traditional refinance — a loan that replaces your current mortgage with a new loan for the same amount. They typically have higher interest rates than a traditional refinance, but lower rates than home equity loans and HELOCs.
How a cash-out refinance works
A cash-out refinance taps into your home’s equity, giving you access to cash that you can withdraw in a lump sum. Most lenders only allow you to refinance a maximum of 80% of your home’s current value — the maximum loan-to-value ratio — for conventional and FHA loans. After you subtract what you owe, which pays off your first mortgage balance, you can collect the rest in cash.
So, if your home is valued at $200,000, the highest loan amount for your cash-out refinance could be $160,000, or 80%. If you owe $100,000 on your current mortgage, you could receive $60,000 in cash to put toward expenses like renovations or to pay down debts.
Cash-out refi costs and fees
Whenever you refinance, you’re taking out a new mortgage, which requires a loan application and closing costs. Although closing costs vary by state and lender, you can expect to pay about 2% to 5% of the loan amount — that’s between $4,000 to $10,000 on a $200,000 mortgage.
When a cash-out refinance makes sense
A cash-out refinance could be a good idea if you’ve had your mortgage for a few years and built some equity in your home. You can use the cash for a large purchase and may be able to secure a lower interest rate at the same time. And there may be tax benefits if you use the money to make home improvements to increase your home’s value. Consult a tax professional for more information specific to your situation.
When a cash-out refinance may not be a good idea
You may want to avoid a cash-out refinance if you don’t intend to stay in your home very long, and the closing costs outweigh your savings.
It may be a good idea to steer clear if a cash-out refinance adds PMI back into your monthly payment. You could stand to lose any potential savings from a lower interest rate if you add PMI to your monthly payment, which can cost about 0.3% to 1.2% of the loan amount every year — that’s an extra $50 to $200 per month on a $200,000 mortgage.
Pros and cons of a cash-out refinance
There are reasons to get a cash-out refinance, but they also come with a few risks.
- Lower interest rates. Compared to other loans like personal loans, home equity lines of credit (HELOC) and home equity loans, a cash-out refinance typically costs less in the long run.
- Cash for large expenses. Homeowners usually use the extra money for home improvements, college tuition or to consolidate and pay down debts.
- Potential tax deductions. If you use the cash to improve your home, you’re adding value to your property. Deducting the mortgage interest could cut your taxes. Consult with a tax professional to see if you qualify.
- Higher interest rate. Cash-out refinances have a higher interest rate than traditional refinances — that also means higher monthly mortgage payments.
- May take longer to repay your debts. If you use your cash-out refinance to consolidate debt, you’re spreading out the repayment period throughout the entire loan term. This may cost you more in interest payments over the course of the loan.
Cash-out refinance alternatives
If a cash-out refinance doesn’t make sense, consider a few other options.
- HELOC. A home equity line of credit works like a credit card. You can withdraw from this revolving line of credit up to the loan maximum during the draw period and only pay interest. Then, during the repayment period, the HELOC switches to a variable-interest rate where you’ll pay back the loan balance plus interest.
- Home equity loan. Another loan that taps into your equity with a fixed interest rate that gives you a lump sum of cash to spend as you choose.
A cash-out refinance is about the numbers. If you intend to stay in your home long term and can secure a lower interest rate, a cash-out refinance may be a good idea. But crunch the numbers by comparing your refinancing options to make sure it’s worth the closing costs.
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