Cash Out Refinance 101: The Essential Guide

What Is A Cash-Out Refinance?

A home is going to be one of your largest financial commitments, so you probably want to make it as pleasant and modern as possible. However, saving up enough money to pay for major home repairs and upgrades can be challenging.

Perhaps what you need is a cash-out refinance. It can help you meet your home improvement goals, so you don’t have to rely on credit cards, a personal loan or a second mortgage. You can utilize the equity in your home to pay for home repairs or other debts such as student loans entirely with the help of a cash-out refinance.

A cash-out refinance is a type of mortgage refinance that allows you to convert home equity into cash. A new mortgage is obtained in excess of your prior mortgage balance, and the difference is paid to you in cash.

Miniature house with magnifying glass next to it.

How Does A Cash-Out Refinance Work?

Your home’s equity grows as your mortgage matures. To have equity in a home means to have paid off a certain percentage of the home’s original purchase price. A homeowner’s equity is the value of their stake in their house. Equity is defined as the difference between the value of your home and the amount owed to your lender. As you make payments on your mortgage, you reduce your principal — the size of your loan – and you develop equity.

If you still owe money on your mortgage, you own only the portion of your home that has been paid off. Until you pay off your mortgage, the remaining equity belongs to the lender.

For example, let’s assume you buy a home for $200,000 with a 20% down payment of $40,000. Assuming a 20% down payment, your equity in the home after closing would be $40,000. With each mortgage payment you make, the balance of your loan decreases, and you develop more and more equity (provided your home value doesn’t diminish). When you have paid off your mortgage in full, you own your house fully as well. 

You can gain equity in two ways:

1. Your home increases in value.
2. You pay down your mortgage balance with your monthly mortgage payments. With each mortgage payment you make, you increase your stake in the property.

If you have built up enough equity in your home, you may be able to refinance your mortgage into a larger loan and receive cash in exchange. To put it another way, when you do a cash-out refinance, you take out a loan for an amount more than what you owe on your mortgage.

A cash-out refinance is a way to get rid of your current mortgage and replace it with a new one without taking out a second mortgage.

You are free to spend the funds obtained through a cash out refinance in any way you see fit. You can fix up your house, pay off your student loans, or pay for emergency expenses like car repairs or medical bills. Credit card interest rates are typically higher than those available through cash-out refinancing. A cash-out refinance could be a good choice if you need money for unexpected costs.

Cash-Out Refinance Example

Assume you paid $60,000 on a $200,000 property. This means you still owe $140,000 on your house. Suppose you want to spend $20,000 on renovations.

A cash-out refinance allows you to take a portion of your equity and apply it to your new mortgage principal. This means your new mortgage would be worth $160,000 – the original $140,000 you owned on the house plus the $20,000 you need for renovations. Your lender will provide you the $20,000 cash a few days following closing.

What Are Some of The Requirements Needed for Cash Out Refinancing?

A Credit Score Of At Least 580

A credit score of at least 580 is normally required to refinance. For cash-out refinances, many lenders want higher credit ratings.

Refinancing VA Loans: If you have a median FICO® Score of 580 or higher and are eligible for a VA loan, you can take cash out as long as there is at least 10% equity left in the home after the refinance. With a 620 qualifying credit score, you can borrow up to the full amount of your equity with a VA loan. A VA loan is a mortgage loan made accessible to service members, veterans, and their surviving spouses by the United States Department of Veterans Affairs.

Refinancing FHA Loans: If you are an existing client of mortgage broker with a median credit score of 580, an FHA loan may be used to pay off debt at closing. Otherwise, a 620-credit score is required for any other cash out purposes.

Refinancing Conventional Loans: Regardless of how much equity you’re borrowing against, conventional loans always demand a 620 qualifying credit score.

A Debt-To-Income Ratio (DTI) Of Less Than 50%

The amount of your monthly debts and payments divided by your entire monthly income is your DTI ratio. For example, if you spend $1,500 in monthly costs, including your mortgage, and have a total monthly household income of $4,000, your DTI is $1,500 divided by $4,000, or approximately 37.5%. Most lenders prefer customers with a DTI of 50% or less when refinancing their home loans. However, with FHA or VA loans, it is possible to qualify with bigger debt loads.

Equity in Your Home

If you want to achieve a cash-out refinance, you must already have significant equity in your house. Remember that unless you qualify for a VA refinance, your lender will not allow you to cash out 100% of your equity. Before you commit, take a close look at your current equity. Make certain that you can convert enough equity to achieve your objectives.

Determine How Much Cash You Need

Determine how much money you require once you’ve determined that you meet the conditions for a cash-out refinance. If you intend to utilize the funds for repairs or upgrades, get a few quotations from local contractors so you know how much you need. If you wish to refinance to consolidate debt, gather all of your credit card and bank statements and figure out how much cash you need to pay your obligations.

Reasons to Consider A Cash-Out Refinance

  • Fund Home Improvements and Renovations
  • Consolidate Debt
  • Consolidate debt with a cash-out refinance.
  • Get A Lower Interest Rate
  • Free Up Money to Invest

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A cash-out refinance is a great option for homeowners who need cash in hand, meet the requirements of the refinance loan and generally need no more than 80% of their home’s equity. Because of their lower interest rates, cash-out refinances can be a better option than financing with a credit card. The downside is that a cash-out refinance will remove the ability to save equity because it will sometimes force you to put your cash toward the balance. Some other factors that should be considered before getting a cash-out refinance include the need for the cash, the loan type, and borrower credit score. So, be sure that you know the ins-and-outs of this type of financing before taking it up.

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