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Featuring Guest Author: Kent Hendrix, Loan Officer
What is a Cash-Out Refinance?
Picture this, a few years have passed since you bought a house with a mortgage. With your current circumstance, you might be wondering if you’re able to lower your rate, lower your monthly payment, or take out cash. What do you do?
This is where a refinance comes in. To put it briefly, a refinance is the replacement of an existing mortgage with another mortgage under different terms. Many homeowners seek a refinance to lock in a lower interest rate, remove mortgage insurance for a reduced monthly payment, or take out some of their home equity. The various things you can do with a refinance present two refinance types: standard or rate-and term, and cash-out. We will be covering the latter option in this article.
A cash-out refinance is exactly what it sounds like. Homeowners looking to put extra money in their pocket will move forward with a cash-out refinance to well, take cash out! Obtaining a cash-out refi will be similar to obtaining a standard refi, though there are a few notable differences to be aware of.
Standard Refinance vs. Cash-Out Refinance
Although a standard refi and a cash-out refi are similar in terms of how they are processed, what makes them stand out from each other? Let’s take a look.
A standard refinance (or rate-and-term) is a type of refinancing that allows you to replace your existing mortgage with a new mortgage. This new mortgage will allow you to change the terms of your current one, sometimes with a lower rate and same/different term or same rate and same/different term. Obtaining a lower rate with a standard refinance is not always guaranteed and should be consulted with your trusted mortgage lender. Their professionalism and expertise will give you a better sense of whether or not this option is favorable to your circumstance and financial goals.
On the other hand, a cash-out refinance is the same in terms of replacing your current mortgage with a new one. Only now, the new home loan is priced at a higher amount than your existing one. The difference between your loan amount and the appraised value of your home goes directly in your pocket at closing and is yours to spend. One thing to note is that with this option, a cash-out refinance may give you a slightly higher interest rate due to the increase in the loan amount.
Now, we know what you’re thinking: a higher interest rate is not beneficial to a new mortgage. In this case, it all depends!
Not all homeowners own property for the same reason and will, one way or another, have distinct financial and homeownership goals. Although a cash-out refi may give you a slightly higher rate, being able to take cash out immediately will allow you to use that cash for other urgent expenses.
Reasons to Get a Cash-Out Refinance
If your home is equity is earning low returns, it might be valuable to consider a cash-out refinance. As mentioned, taking cash out at closing can be used immediately for other expenses, as well as the following situations:
- Payoff credit cards with a higher rate
- Improve your appreciating assets
- Pay for college/education
- Invest in real estate
- Invest in higher-yielding investment options
You should note that taking cash out from a refinance should only be considered when other alternatives have been exhausted. Since the process is to obtain a replacement mortgage that might yield a higher rate, it may not be the most viable option for you.
As always, any changes with your mortgage should be consulted with your mortgage lender. Their knowledge of your original loan combined with their expertise in the field will allow them to listen to your reasons on why you need a cash-out refi, decide if it’s a good route and if it’s not, hopefully, some alternative routes will be attainable.
How Does It Work?
The process to qualify for a cash-out refinance is very similar to qualifying for a regular home-rate refinance. First, your mortgage lender receives a new market appraisal on your current property and creates a new loan that does not exceed 80% of this value. This concept is also referred to as your loan-to-value ratio.
The loan-to-value ratio, or LTV, plays a valuable role in a cash-out refinance because it determines how much risk your mortgage lender is taking on. LTV “measures the relationship between the loan amount and the market value of the asset securing the loan, such as a house” (Experian, 2020). To calculate LTV on your current home, divide your mortgage balance by the new value of your home, then multiply that amount by 100 to get a percentage.
LTV = (Current mortgage balance / Appraised value of home) x 100
The difference between your loan amount, plus closing charges and the state-specific percentage cap of the appraised value of your home goes directly in your pocket at closing and is yours to spend.
Cash-Out Refinance vs. Home Equity Loan
Now that we’ve gone over the fundamentals of a cash-out refi, how does one differ from a home equity loan? For starters, a home equity loan doesn’t replace your current mortgage as a typical refinance.
A home equity loan is a second loan that allows you to borrow against the equity in your home. Since it is an entirely separate loan from your mortgage, this assumes that the terms on your original mortgage will not change. This loan option also tends to have higher interest rates than original mortgages. At closing, you receive a lump-sum payment from your mortgage lender, which you are obliged to repay at a fixed rate.
Home equity loans aren’t the same across the board. These programs can vary by state and thus, have different regulations that may restrict your ability to purchase. For example, in Texas, a home equity loan is not a mortgage but a separate loan that uses the same 80% of the market value rule. This loan option also tends to carry a higher interest rate given that it is not a “mortgage”. It’s important to note that the interest paid on the home equity loan may or may not be considered tax-deductible. In most cases, the home equity loan is on a draw, meaning you may not receive the entire proceeds at closing.
Although cash-out loans are new mortgages replacing your existing ones, you may be eligible for the more competitive rates in the market, even if it’s a slightly higher rate than your original one. Your entire home loan will carry the new interest rate forward for the term of the loan.
Success with a Cash-Out Refinance
Kent Hendrix, known as the Mortgage Mind of Texas, has had successful experiences working with cash-out refinances. He notes that most of his clients use cash-out options to leverage their money and put it in higher-priority items, ultimately making it work better for them.
My clients can pay for their kids’ college instead of taking out school loans or they pay off other bills that carry a higher interest rate. Many times, they see that the new payment is less than their current payment and that they can get out from debt that would otherwise take them years to pay off.
Kent has also worked with clients who opt for a cash-out refinance to make improvements and renovations to their homes. This, in turn, increases the market value of their home later down the road and could gain a higher return when they eventually decide to sell.
Although many of Kent’s clients have various purposes for refinancing, their ability to communicate with him and relay their goals allows Kent to do what’s best for their situation and alleviate some financial burden.
Is a Cash-Out Refinance Right for You?
Cash-out refinances are common in the industry, solely because of the instantaneous ability to get cash out at closing and put it towards other expenses. In the short run, this option fulfills any personal or financial setbacks that demand that extra cash right away. On the other hand, you may be left with a higher interest rate.
Before considering a cash-out refinance, are there other ways to obtain the cash you seek? One thing to note is a refinance is not always the best possible solution for every scenario and should be discussed with your mortgage lender. A standard refinance may be more ideal if you are only looking to change the current terms of your mortgage, such as finding a lower interest rate or lowering your monthly payment. If lowering your monthly payment is a more valuable decision, check out our blog on how to avoid mortgage insurance and keep us posted on your success!
About the Guest Author
Kent maintains a Masters in Business Administration from the University of Texas and an undergraduate degree in Psychology from Oklahoma Baptist University. He is currently using past experience as a licensed certified financial planner to assist potential homeowners secure mortgage loan financing. Past positions include being the director of physician services for Smith & Nephew and owning his own business. Learn more.
Financing details are for educational purposes only. Rates, program terms, fees, and conditions referenced are subject to change without notice. Not all products are available in all states for all amounts. All mortgage applications are subject to underwriting guidelines and approval. This is not an offer of credit or a commitment to lend. Residential Wholesale Mortgage, Inc. dba RWM Home Loans is an equal housing lender licensed by the CA Department of Real Estate #01174642 and CA Department of Financial Protection and Innovation under the California Residential Mortgage Lending Act. NMLS# 79445