Is a cash-out refinance a good idea?
Homeowners tapped their home equity for a record-breaking amount of cash in 2021.
This cash-out refinancing trend is expected to continue into 2022 as borrowers take advantage of low refinance rates and record-high equity, according to mortgage data firm Black Knight.
If you’re wondering whether a cash-out refinance is a good idea or how a cash out refinance works, here’s what you should know about the benefits and how to do it safely.
In this article (Skip to...)
- How it works
- When to consider
- Is now a good time
- Today’s refinance rates
How a cash-out refinance works
If you need to borrow a large sum of money, and you have plenty of home equity, a cash-out refinance is often the cheapest way to do it.
A cash-out refinance lets you borrow against the value of your home. Since these are secured loans — meaning the house is used as collateral — they have much lower interest rates than other types of loans.
For example, current mortgage interest rates for borrowers with strong credit are around the mid-3% range — whereas personal loan rates range from about 6% to over 20%.
Lower rates aren’t the only reason to consider a cash-out refinance, either.
Cash-out refinancing benefits
- You could lock in a lower interest rate on your home loan
- You can use the funds for any purpose; debt consolidation, home renovations, and home improvements are popular uses
- You don’t need a specified purpose for the funds; you can even put them toward things like emergency funds and investments
- You have the option to shorten your loan term or change loan programs when you refinance
Generally, a cash-out refinance is worth it if you need cash and you can benefit from refinancing your existing loan.
Smart uses for a cash-out refinance
Putting your cash-out funds to good use could even improve your overall financial situation.
For example, debt consolidation can give you a fresh start if you find yourself with high credit card balances or other high-interest debts. And, provided you don’t run those debts up again, you could save hundreds each month in interest repayment and transform your personal finances.
Many homeowners also use cash-out funds to make home improvements that increase the value of the property and net a bigger profit when they eventually sell. In this way, they see a greater return on their refinance.
You can also use the lump sum of cash as a down payment on an investment property.
Lastly, if you did not put a 20% down payment on your conventional loan back when you were a home buyer, then your existing mortgage carries private mortgage insurance (PMI). Another benefit of refinancing is that it will remove PMI and lower your monthly mortgage payment.
But of course, a home loan refinance isn’t the right decision for everyone.
Drawbacks of cash-out refinancing
- There are closing costs (typically 2%-5% of the new loan amount)
- You re-start your mortgage term, usually for another 15 or 30 years
- If your home’s value drops, you could owe more on your mortgage than the home is worth
- If you can’t make loan repayments, you could face a foreclosure
The risks of cash-out refinancing are similar to any mortgage: if the loan defaults, your home is on the line.
But there’s a little more to consider here, because with a cash-out refi, your new loan amount is higher than your original mortgage. Your monthly payments could potentially be higher, too.
When to consider a cash-out refinance loan
These drawbacks mean a cash-out refinance typically isn’t best if you only need to borrow a small amount of money, or if you won’t see a return on your investment (like using a cash-out refi to pay for a vacation or a new car).
Refinancing typically isn’t ideal if you’re close to the end of your mortgage term, either.
But if you can benefit from a refi and you’ll put the funds to good use, a cash-out refinance can be an optimal way to finance big expenses.
With today’s real estate values on the rise, cashing out home equity is a safer prospect than it was in the past.
Is now a good time to get a cash-out refinance loan?
Average 30-year mortgage rates hit 16 new all-time lows in 2020. And 2021 kicked off with another record low of 2.65% on January 7, according to Freddie Mac.
But then interest rates started to rise.
Of course, there’s always a chance rates could drop again. But it’s more likely they’ll go higher. Check out today’s mortgage refinance rates to see.
Rising rates could make a cash-out refi less attractive to many homeowners in the near future — especially those who already have a low rate, and could potentially increase their mortgage payments and interest cost by refinancing.
If rates go up substantially, it may be better to leave your current mortgage in place, and opt for a home equity loan or HELOC. That way you’re paying a higher rate on a smaller loan amount, and you leave your current mortgage intact.
If you’ve been on the fence about a cash-out refinance, now’s probably the time to get serious about applying.
Who is eligible for a cash-out refi?
Pre-housing crash, it was far easier — almost too easy — to cash out home equity. That’s part of the reason these loans sometimes get a bad rap.
But those days are gone. Today, you can expect mortgage lenders to comb through your personal finances before giving you the green light for a cash-out refi.
Increased scrutiny makes it tougher to get approved for a cash-out mortgage loan than in the past, but it also protects homeowners from unsafe borrowing.
Most lenders have the following minimum requirements for a cash-out refi:
- You must retain at least 20% equity: That means you can borrow the difference between your mortgage balance and 80% of your home’s market value, which will be re-appraised for the loan
- You need a credit score of at least 620: The higher your credit score, the better, as you could get approved for a lower mortgage rate
- You need reliable income and employment: Lenders want to see you can easily afford the new loan’s monthly payments
- Your DTI is below 43%: Your monthly debt payments (housing costs, credit card debt, student loans, child support, etc.) take up no more than 43% of your gross monthly income. This is your debt-to-income ratio or DTI
Typically, you’ll need to get your home appraised before a cash-out refi. Appraisal values can impact the amount of money you can extract from your home’s equity, as they establish a home’s value for the loan-to-value ratio (LTV).
Of course, it’s your job to make sure you can comfortably afford your new loan. But, if you can clear these hurdles, you may well be in good enough financial shape.
Cash-out refinances vs. other types of loans
We’ve said a couple of times that cash-out refinances are great for borrowing large sums. But, unless you want to refinance anyway (perhaps you can reduce your mortgage rate and monthly payment), they’re not an ideal way to borrow small amounts of money.
That’s because a cash-out refinance is a whole new mortgage. And you have to pay closing costs, just as on your existing mortgage.
Given that upfront fees are typically 2%-5% of the mortgage’s value, that’s likely to be several thousand dollars. And paying thousands to borrow just a few thousand doesn’t make financial sense.
Home equity loans (HELs)
Like a cash-out refi, a home equity loan lets you borrow a large lump sum from the equity in your home.
Home equity loans also usually have closing costs in the 2%-5% range. But you pay those only on the amount you’re borrowing (not the full mortgage amount). So the total cost will be lower. And, these loans have only slightly higher interest rates than cash-out refinancing.
Meanwhile, home equity loans have another advantage over cash-out refinances. Namely, you don’t reset your mortgage term.
Unless you opt for a shorter term, refinancing means you end up paying for your house over a longer period.
Suppose you’ve had your home for 10 years. And you refinance to a new 30-year mortgage. You’ll be paying your home down over 40 years. And that’s 40 years of paying interest, which isn’t cheap, no matter how low rates are.
A home equity loan avoids that issue by leaving your original mortgage intact.
Home equity lines of credit (HELOCs)
A home equity line of credit (HELOC) is a bit like a credit card in that you’re given a credit limit and can borrow up to that sum. You pay interest only on your outstanding loan balance, and can borrow, repay, and re-borrow as often as you wish.
Like HELs, HELOCs are second mortgages. But, unlike HELs, they tend to come with small or zero closing costs. So these are a better way to borrow smaller sums — or large ones over a brief period. Interest rates are typically a bit higher than for HELs.
For most borrowers, rates on personal loans are appreciably higher than for cash-out refinances, HELs, and HELOCs.
However, a few lenders offer personal loans to the very best borrowers (stellar credit scores, high incomes, and lots of assets) at similar rates.
The upside is these are unsecured loans, meaning they’re not tied to an asset. So, unlike with mortgages and second mortgages, you’re not putting your home on the line if loan repayment goes wrong.
Explore your options and refinance rates
Cash-out refinances are safer and more affordable than they were years ago.
It’s likely you’ll be able to take cash out no matter what type of mortgage you have. These loans are commonplace for conventional, conforming, FHA and VA loans. Only USDA loans ban cash-out refinancing.
Of course, while you’re at it, you should fully explore your refinance options.
For example, why stick with an FHA loan when you could refinance to a conventional loan without private mortgage insurance?
And, naturally, you should shop around between multiple lenders to make sure you get the full benefits of cash-out refinancing, including the lowest possible refinance rate and loan closing costs.