Are you in urgent need of money? Well, if you own a house, you can seek Cash-out refinancing. Cash-out refinancing can provide homeowners with much-needed financial relief. In many cases, it allows them to take advantage of lower interest rates and save money on their monthly mortgage payments. So, a cash-out refinance puts cash in your pocket when you need it the most. However, homeowners should be aware of some potential drawbacks of cash-out refinancing before deciding to do so.
What is Cash-Out Refinancing?
Cash-out refinancing is a refinance loan that allows homeowners to get cash back on mortgage refinances. Mortgage lenders grant homeowners a bigger mortgage than the original mortgage. Essentially, it enables homeowners to take equity out of their homes and use it for other purposes. For example, homeowners might use the money from a cash-out refinance loan to improve homes, pay down high-interest debt, or cover unexpected expenses. However, they cannot borrow more than 80% of the home's equity. But a VA loan borrower can borrow up to 100% of the home's value on a VA cash-out refinance.
How Does Cash-Out Refinancing Work?
When homeowners opt for a cash-out refinance loan, they are essentially taking out a new mortgage loan that is larger than their current residential mortgage. The difference between the existing mortgage and the new loan is then given to the homeowner in cash. So, when you opt for a cash-out refinance, you land yourself into a bigger mortgage with higher monthly payments or an extended loan term in exchange for quick cash. To qualify for a cash-out refinance loan, refinance mortgage company requires homeowners to have at least 20% equity in their home.
Let's understand it with a simple example. Suppose you own a home worth $200,000 and have a mortgage balance of $100,000. You want to make some home improvements that will cost you $30,000. You decide to take out a cash-out refinance loan for the repairs. Thus, you will take out a new mortgage loan for $130,000. Your old mortgage of $100,000 will be paid off, and you will receive $30,000 in cash that can be used for the home repairs.
Now that we have a clear understanding of how cash-out refinancing works let's look at its pros and cons.
Cash-Out Refinancing Pros
Quick Cash: Cash-out refinance gives homeowners access to cash when they need it the most. In many cases, it provides them with the much-needed financial relief they are looking for. It also enables them to take advantage of lower interest rates and save money on their monthly mortgage payments.
Improves Equity: Cash-out refinancing can help homeowners improve their home equity. Home equity is the portion of the home's value owned by the homeowner. You increase your home equity when you take out a cash-out refinance loan to make home improvements. This can be beneficial if you want to sell your home in the future as it will increase its resale value.
Lowers Interest Rates: Cash-out refinancing can help homeowners reduce their interest rates. If interest rates have decreased since you took out your original mortgage, you could save money by refinancing your loan. Thus, you can enjoy lower interest rates and save money on monthly mortgage payments.
Consolidates Debt: Cash-out refinancing can also be used to consolidate debt. For example, homeowners can use the cash from the refinance loan to pay off high-interest debt such as credit cards. Thus they save money on interest payments and get out of debt sooner.
Potential Tax Benefits: Cash-out refinancing can provide homeowners with potential tax benefits. The interest paid on a mortgage cash-out refinances is generally tax-deductible. Thus, you potentially save money on your taxes by refinancing your loan. However, suppose you are using the extra money from a cash-out refinance on non-home expenses such as consolidating credit card debts or paying for child education. In that case, the interest amount is not tax-deductible. Only money used on home improvements enjoys tax benefits.
However, homeowners should be aware of some potential drawbacks to cash-out refinancing before deciding to go through with it.
Cash-Out Refinancing Cons
Closing Costs: Cash-out refinancing requires the payment of closing costs for processing and approving a refinance loan. Closing costs can add up to several thousand dollars and must be paid upfront. Thus, homeowners who are tight on cash are at a significant disadvantage.
Risk of foreclosure: Cash-out refinancing increases the risk of foreclosure. Homeowners essentially take on more debt when they refinance their loans. If they cannot make the monthly payments, they could lose their home to foreclosure.
Overall Higher Interest: The benefits of Cash-out refinancing come with a cost. Cash-out refinancing can end up costing homeowners more in the long run. Refinancing restarts your mortgage. Thus, homeowners will be paying interest on the entire loan amount, not just the portion used to pay off the old mortgage. Moreover, as the loan period is extended, they could pay more interest over the life of the loan. One way to overcome this drawback is to choose a shorter term for refinance.
Now that we have looked at the pros and cons of cash-out refinancing let's look at some alternatives.
Home Equity Loan: A home equity loan is a second mortgage taken out by a homeowner. The loan is based on the equity in the home and can be used for any purpose. Home equity loans generally have lower interest rates than credit cards or personal loans. They also offer the potential for tax deductions. However, they come with closing costs and foreclosure risks.
Home Equity Line of Credit: A home equity line of credit is similar to a home equity loan. It is a second mortgage based on the equity in your home. However, instead of receiving a lump sum of cash, you are given a credit limit that you can borrow against as needed. HELOCs generally have lower interest rates than credit cards, but they are variable and change with the prime rate. However, they require the payment of closing costs and have the same risks as cash-out refinancing.
Personal Loan: Personal loans can be used for any purpose. They are not secured by your home and typically have higher interest rates than home equity loans or lines of credit. However, they do not require the payment of closing costs, and there is no risk of losing your house if you cannot make the payments.
Reverse Mortgage: A reverse mortgage is a loan available to homeowners age 62 or older. It allows you to borrow against the equity in your home without making monthly payments. The interest and principal are not due until the borrower dies, sells the house, or moves out of the house. Reverse mortgages have high-interest rates and fees, so they should be used as a last resort.
Conclusion
So, what is the best option? It depends on each homeowner's circumstances and the time taken for the refinancing process. If you need urgent cash and have equity in your home, cash-out refinancing may be suitable. But if you are tight on money or worried about the risk of foreclosure, consider one of the alternatives. However, make sure you are aware of the risks involved and compare alternatives to see if there is a better option.