The answer: a cash out refinance. A cash out refinance lets you pocket some of the value of your home. You see some instant return on all those mortgage checks you’ve sent in. Here’s how it works.
Cash Out Refinancing: The Basics
Like any refinance, a cash out refinance is a new loan. You replace your existing mortgage with a new (and improved, we hope) refinance mortgage. With regular refinancing (also known as rate and term refinance), you get a new mortgage equal to the amount you still owe on your home. Your new mortgage could be designed to change the length of your mortgage term, or to change the interest rate you pay. But with cash out refinancing, you get a new mortgage for an amount that exceeds what you currently owe. Then, you cash out the difference.
People use cash out refinancing when they need a lump sum of money, say, to pay off high-interest credit card debt. Cash out refinances often come with longer mortgage terms, to keep borrowers from seeing a big jump in their monthly mortgage bill.
The big, obvious advantage to a cash out refinance is that you get money from your home equity without having to sell the home. You can use that money for anything you want, though often people use the funds for home renovations.
Another advantage to a cash out refinance is that you don’t have to pay taxes on the amount you cash out, and you can still write off interest payments. Nice, right?
- You lose equity: When you commit to a cash out refinance, you forfeit some or all of the equity you’ve worked hard to build. That lowers your net worth, and means you’ll get less out of a future home sale.
- You could end up under water: If you give up home equity to take on a cash out refinance, you run the risk that the value of your home could drop. You could end up owing more than your home is worth. Not good.
- You pay more interest: The more you borrow, the more interest you pay. That means less money in your pocket and more money for the Wall Street Fat Cats. Or whomever. Remember that with a cash out refinance, you pay interest on the money you cash out. It’s not free, even though it’s your equity that you’ve built.
- You might not break even: Refinancing means paying closing costs anew. So if you take a few thousand out in your cash out refinance, but pay a few thousand in fees to close the mortgage, you won’t come out ahead. And you’ll be paying interest on the amount you cashed out. Or, if you refinance and then move right away, you might not be in the payday loans Hamilton home long enough to break even.
- Cash out refinancing could come with a higher interest rate than than the rate you currently have, depending on your circumstances and your lender. Higher rates mean more interest over the life of the loan.
- You could struggle to pay back the loan: If you sign on the dotted line for a hefty new mortgage as a cash out refinance, you’re taking on more debt. If a job loss or illness cuts into your budget, you could find it hard to keep up with payments.
Cash Out Refinance Rules
The rules of cash out refinance vary from lender to lender, but there are some universal truisms. Lenders generally require that borrowers stick to a “seasoning” period of 12 months before committing to a cash out refinance. In other words, you’ll need to have owned the home for a year before seeking a cash out refinance. Cash out refinances also usually come with a loan-to-value ratio (LTV) rule. You probably won’t be able to get a cash out refinance mortgage with more than an 80% LTV.
When you’re considering a cash out refinance, you don’t have to prove that you can afford the extra debt, or that you’re planning on using the cash for paying off high-interest debt or making investments. You could cash out some huge percentage of the value of your home and blow all the money on shoes – there’s no rule against it. The catch is that you still have to keep up on the payments for your new, bigger mortgage. And as we’ve covered, there are some risks involved.
Although cash out refinancing is not without risk, it could still be the right move. If interest rates have dropped significantly and you need to pay off high-interest debt, tapping your home equity could be a great move, especially if you’re planning on staying in the home for decades to come.
If you don’t need cash but you do want to take advantage of lower interest rates, consider a regular old rate and term refinance. You’ll still have to pay the closing costs, but you won’t be taking on more debt than you already have.