When to Consider a Cash-Out Refinance

A cash-out refinance allows homeowners to gain access to some of the equity in their homes. However, there are some things to consider before applying for one.

Photo by Binyamin Mellish on Pexels

A cash-out refinance loan can be a great way to tap some of the equity in your home. However, the costs associated with this type of mortgage loan may give some homeowners pause.

If you have a significant amount of equity in your home that you're hoping to use to pay off high interest credit cards, make some home improvements or just about anything else you can think of, here's what you should know about a cash-out refinance.

What Is a Cash-Out Refinance?

A cash-out refinance loan is a mortgage loan that replaces your existing home loan, complete with new terms. Unlike a traditional refinance loan, however, a cash-out refinance loan allows you to take cash out of your home's equity on top of the original loan amount.

For example, let's say your home is worth $300,000, and your mortgage loan balance is currently $100,000. If you're thinking of making some improvements to your home that will cost $50,000, you could use a cash-out refinance to effectively take that amount from your home's equity. The new loan will combine the $100,000 balance it paid off from the original loan plus the $50,000 you took out in cash for a total of $150,000.

Lenders typically require that you maintain at least 20% in equity — on a $300,000 home, that means your cash-out refinance loan can't exceed $240,000 — but that limit can vary by lender.

A cash-out refinance isn't the only way you can tap your home's equity, though. Here's how it compares to a home equity loan and home equity line of credit (HELOC).

Cash-Out Refinance Loan vs. Home Equity Loan

Both of these loan options give you a lump-sum amount upfront, which you'll pay off over a set period determined by you and your lender.

That said, a cash-out refinance loan is a primary mortgage loan, which means that you're only borrowing money from one lender. With a home equity loan, you're taking out a second mortgage loan from a lender that may not be the same as the one that services your primary mortgage. Instead of one monthly payment, you'll have two.

Additionally, home equity loans are referred to as subordinate loans. This means that if you can't make your payments and the original lender forecloses on the home, the home equity lender only gets paid if there's enough money left over after the original lender sells the home and recoups its loan balance, interest, and fees.

As a result, home equity loan interest rates tend to be a bit higher. That said, closing costs on a home equity loan are only applied to the amount you're taking out of your equity, whereas with a cash-out refinance, you're paying closing costs based on the cash portion and the original loan amount. Some home equity lenders may not charge closing costs at all.

Cash-Out Refinance Loan vs. HELOC

With a cash-out refinance, you're getting a lump-sum payment that you can pay back over time. In contrast, a HELOC gives you a revolving line of credit that you can use, pay off and repeat — similar to the arrangement you have with your credit card companies.

A HELOC can be worth considering if you want access to funds over a long period of time rather than all at once. You'll have a draw period, during which you can take withdrawals for anything you want and pay only interest on what you've borrowed. After that, the repayment period kicks in, during which you'll make regular monthly payments over a set period on whatever balance remains from your draw period.

Another key difference between the two options is that cash-out refinance loans can come with a fixed or adjustable interest rate, while HELOC interest rates are almost always variable. This means that the rate will fluctuate along with market rates and can ultimately cost you more money.

HELOCs may also come with an annual fee, but some don't charge closing costs, giving you fewer upfront expenses. Like home equity loans, HELOCs are subordinated loans, so they may come with higher interest rates than a cash-out refinance.

Pros and Cons of Cash-Out Refinance Loans

If you're considering a cash-out refinance, it's important to understand both the benefits and the drawbacks. Here's what you should keep in mind.

Pros

• Potentially lower interest rate: You'll generally get a lower interest rate on a cash-out refinance compared to a home equity loan or HELOC, and you might even be able to get a lower rate than what you're paying on your existing mortgage loan.

• Access to funds: Having a lot of equity in your home is a good thing, but unless you have plans to move soon, you can't access that money without using a cash-out refinance or home equity product. If you have some significant expenses coming up, it could save you money compared to a personal loan or credit card. What's more, there aren't really any restrictions on how you can use your cash-out refinance funds.

• Simplicity: Unlike with a home equity loan or HELOC, you'll only have one loan and one monthly payment.

Cons

• Potential for higher monthly payment: Because you're borrowing more than your original loan balance, your monthly payment could end up being higher than what it was before. However, this will depend on how long you've had the loan, the original principal amount, the interest rate, and the repayment term. If your payment does end up being higher, it could put you at a greater risk of foreclosure.

• Closing costs: Closing costs on a cash-out refinance can range from 2% to 5% of the loan amount, which can easily result in thousands of dollars that you have to pay upfront. While some lenders will allow you to roll the closing costs into the loan amount, this will only increase your monthly payment and total interest charges.

• Potential for private mortgage insurance: If you find a lender that allows you to borrow more than 80% of your home's value, it could result in needing private mortgage insurance (PMI) until your loan-to-value ratio drops below 80% again. PMI typically costs between 0.5% and 1% of your loan amount every year.

How a Cash-Out Refinance Impacts Your FICO® Score

Getting a cash-out refinance can impact your FICO® Score in a few different ways. Here's how those effects break down:

• Credit inquiry: When you apply for a new loan, the lender will run a hard inquiry, which can impact your FICO® Score a little. The good news is that if you're applying with multiple lenders within 14 or 45 days, depending on the FICO scoring model, those will all combine into one inquiry for scoring purposes.

• Loan payoff: Each time you pay off an old loan, it can impact your FICO® Score temporarily.

• New loan: When you add a new credit account to your credit reports, it reduces your average age of accounts, which can impact your length of credit history negatively.

• More debt: How much you owe is a key factor in your FICO® Score, and depending on how much you take out of your home's equity in cash, it could hurt your FICO Score.

Note that the impacts from each of these factors can vary depending on the makeup of your credit profile. However, as long as you use credit responsibly and make your payments on time, there shouldn't be any long-lasting negative effects.

Also, keep in mind that building a good credit score before you apply for a cash-out refinance can make it easier to qualify for lower interest rates and fees.

Should You Consider a Cash-Out Refinance?

A cash-out refinance loan may be worth considering if you need access to some of your home's equity. Here are some situations where it might make sense:

• You have great credit and can qualify for a lower interest rate than what you're currently paying.
• You have enough cash to cover the upfront closing costs.
• You plan to live in your home long enough that your interest savings compared to another loan option outweigh the upfront costs.
• You want to switch from an adjustable interest rate to a fixed interest rate.
• You're thinking of using the funds to improve your financial situation.
• You're okay with waiting a while, as the underwriting process can take several weeks.

Because of the costs associated with a cash-out refinance, it's generally best to avoid using one for expenses that won't provide some kind of return. While using one to fund a vacation or buy a new car might sound tempting, it may ultimately make your financial situation worse in the long run.

Ben Luthi

Ben Luthi has been writing about money and travel for seven years. He specializes in consumer credit and has written for several major publications and industry leaders, including U.S. News and World Report, Fox Business, Wirecutter, Experian, and Credit Karma.