How to tap home equity without a cash-out refinance
If you need a large sum of money, you may be tempted by a cash-out refinance.
A cash-out refi replaces your existing mortgage loan with a larger loan. The new loan is large enough to pay off your current loan and pay you cash at closing. This type of refinance loan might be your best way to borrow the money you need, but it’s not always the right option.
Here’s what you should know before applying.
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Downsides of a cash-out refinance
Any type of refinance loan requires closing costs. These costs usually range between 2% and 5% of the new loan amount and include legal fees as well as origination fees.
The larger your loan, the more you’ll pay in closing costs. Since cash-out refinances usually have larger loan amounts, closing costs are higher.
A cash-out refinance is large because the new loan amount has to covert:
- A new mortgage loan that pays off your existing mortgage balance, and
- A cash loan that’s secured by your home equity — the part of your home value that exceeds your current mortgage debt
Along with higher closing costs, cash-out refis usually charge higher interest rates because the lender faces more risk of default.
Paying more may be worthwhile when you need both features of a cash-out refi: The new mortgage and the cash-out loan. But if you don’t want to refinance your existing home loan, a cash-out refinance may not be the right choice.
How to get cash-out without refinancing: 4 strategies
If you already have a low, fixed-rate mortgage, or if you’re well on the way to paying off your current mortgage, a cash-out refi might not make sense. Instead, you can consider a home equity line of credit (HELOC) or a home equity loan. These ‘second mortgages’ let you cash-out your home’s value without refinancing your existing loan.
1. Home equity line of credit (HELOC)
A home equity line of credit, or HELOC, offers a better financing strategy for borrowers who want to keep their primary mortgages intact.
A HELOC resembles a credit card, except the loan is backed by your home value which allows the lender to charge a much lower interest rate.
You’d draw from the line of credit as needed and then repay the balance by making monthly payments. During your HELOC’s draw period, which can last up to 10 years, you can borrow and repay funds as needed.
All the while, you’d keep paying your existing mortgage payments along with the new HELOC’s monthly payment. Note that during the HELOC draw period, you pay interest only on the outstanding balance charged to the line (not the full credit limit).
This type of loan works well when you don’t need a large lump sum for a big purchase or project.
With its lower closing costs and added flexibility, a HELOC is usually less costly than a cash-out refinance, and it takes less time to close. There aren’t limitations on its use, and you only pay interest on the amount of credit used.
You can use the funds for any purpose, including home improvement projects, annual costs like college tuition, or financing a gap in business revenue.
2. Home equity loan
A home equity loan resembles a personal loan except the loan will be secured by your home equity, so you should get a lower interest rate.
Just like with a HELOC, you’d keep making your current monthly mortgage payments while adding a second payment for the home equity loan.
Unlike a HELOC, a home equity loan pays out a lump sum upfront and requires fixed monthly payments until you pay off the loan balance.
Home equity loans work well when you’re making home renovations or paying off existing high-interest debt, but lenders don’t limit how you spend the money. You could use the money to buy a car or make a down payment on a vacation home, for example.
3. Refinance your first mortgage and get a second mortgage
Even if you need both features of a cash-out refinance — a new mortgage and an equity-backed cash loan — a cash-out refi may not be your best deal.
Depending on the amount of cash you need, it might be less expensive to separate the two elements of a cash-out refinance into two separate loans. You’d:
- Refinance your first mortgage with a cheaper rate-and-term loan
- Add a second mortgage (HELOC or home equity loan)
If you have an FHA, USDA, or VA loan, you may be able to save even more with a Streamline Refinance loan — a loan that lowers your rate or monthly payment without checking your credit score or appraising your home.
If you have a conventional loan and can’t get a Streamline Refinance, you may still save with this strategy since refinance rates are lower with no cash-out loans.
Then, your second loan — a HELOC or a home equity loan — could generate the extra amount of money you need.
4. Other sources of cash
Mortgage loans use your home as collateral, so mortgage interest rates tend to be lower than the rates you’d pay on other forms of borrowing. They’re especially lower than rates on credit cards and personal loans which require no collateral.
But a loan against your home equity is still a big loan that will need to be repaid over a long period of time. Depending on your specific needs, accessing another source of cash may be a better plan for you.
For example, if you have vehicle loans at high interest rates, see if you can refinance them. That will give you lower payments and you can use the savings to pay other debt.
Consider selling valuable collections, luxury items or things you’re not using. If there’s still debt left after your selling spree, see a credit counselor about restructuring that to pay it off. They also can help you develop better spending habits.
Consider starting a side hustle using high-demand skills you already have. Look for ways to generate income in the gig economy but carefully research their costs and legal requirements.
Or, you could borrow from family, apply for zero-interest balance transfer credit cards, or borrow against your 401(k) and deduct payments from your paycheck.
These options could reduce your debt load or give you better terms than cash-out refinancing.
What to consider before a cash-out refinance
A cash-out refi is a powerful tool. It may be exactly what you need to build a stronger financial foundation going forward. If so, the closing costs and higher interest rate will be worth the cost.
But before applying for this type of mortgage refinance option, make sure you understand the details. Here are a few key points to be aware of.
How much cash can you withdraw?
Fannie Mae and Freddie Mac set the rules for conventional loans. And they limit the amount of cash you can withdraw from your home equity.
Cash-out refinancing has a loan-to-value limit of 80%. This means you’d need to leave 20% of your home’s current value untouched. If your home was worth $300,000, your new loan amount couldn’t exceed $240,000.
This new $240,000 loan would need to pay off your existing loan. Then, your cash-out would come from what’s left over. If you owed $230,000 on your existing loan, you could get only $10,000 in cash back.
Many homeowners don’t have enough equity to pay off their current loan, leave 20% of equity in the home, and get cash back.
One exception: the VA cash-out refinance can allow borrowers to access 100% of their home’s equity, bypassing the 80% LTV rule. Only veterans, active duty service members, and some surviving military spouses can get VA loans.
Do you meet cash-out underwriting guidelines?
A cash-out refinance is not a source of quick cash; it’s a large loan secured by your home. As a result, underwriting and eligibility guidelines are stricter for these loans and they can take longer to close than shorter-term financing.
Conventional loan lenders look for higher credit scores with cash-out refinancing: Home buyers can get approved with FICO scores as low as 620. For cash-out refinancing, lenders often want to see credit scores of at least 660.
It is worth noting that you can avoid the surcharges and stricter underwriting by choosing government-backed refinance options like FHA and VA.
However, those programs have their own sets of upfront mortgage insurance fees. FHA also charges annual mortgage insurance on all cash-out refinance loans, whereas a conventional cash-out loan has no PMI. So these may not make sense if you have significant home equity.
Are you comfortable changing your loan amount and term?
Cash-out refinancing means you’ll have a bigger mortgage and probably a higher payment. You’ll also burn up some home equity, which is an asset just like your 401(k) or bank balance.
This is not something to do lightly.
In addition, taking a cash-out refinance means resetting the clock on your home loan. You pay more over time by adding those extra years and interest to a new mortgage.
How will you manage your finances after cashing out?
If the reason for your cash-out refinance is debt consolidation, consider other options before you take out this type of refinance loan.
This is especially true if you’re consolidating consumer debt. Depleting home equity to pay off debt accrued buying things that don’t outlast the debt can be risky.
In addition, it can be tempting for some borrowers to run up their cards again and accrue new debt after paying off the old liens. Then they might need another cash-out refi to pay off the new debt, creating a vicious cycle.
That doesn’t mean a debt-consolidation refinance is always a bad idea. It just means you need to have a careful plan in place before doing so.
Talk to a financial advisor about how you plan to pay off your debts and have a clear roadmap in place for better money management after the debt consolidation is complete.
When is a cash-out refinance the best option?
A cash-out refinance may be your best choice when:
- You need cash for a long-term investment such as home renovations or other real estate transactions
- You have plenty of home equity
- Your current mortgage rate exceeds the rate you could get now
- You have a strong credit profile
- You’re a veteran who can get a 100% VA cash-out refinance
Ask lenders to show you other options and help you compare costs when you’re considering cash-out refinancing.
What are today’s mortgage rates?
Current mortgage rates for rate-and-term refinances and cash-out refinancing are affordably low.
However, you still need to compare options and shop among competing mortgage lenders to pay as little as possible for your next loan.
