What is a cash-out refinance? It’s a simple question, but nonetheless pertinent to those looking for the best way to tap into their home’s equity. If for nothing else, there are several ways to cash in on the equity that has returned to the housing market in recent history: home equity loans, reverse mortgages and home equity lines of credit — just to name a few. It is worth noting, however, that each has a specific use, and a cash-out refinance is no exception. More specifically, there are special circumstances that warrant the use of a cash-out refinance, and you need to know them before you even consider borrowing against the equity in your home.
In order to truly understand the concept of a cash-out refinance, you must first familiarize yourself with it’s simpler, more basic counterpart: the standard home refinance. In its simplest form, a refinance replaces an existing loan with a subsequent loan, often at a better interest rate. Most homeowners will, therefore, seek to refinance when interest rates condone doing so. The refinance will proceed to pay off the homeowner’s current loan and replace with another loan at a better rate.
A cash-out refinance, on the other hand, will follow the same procedure as a standard refinance with a simple exception: a cash-out refinance will cover the existing debt, and then some. Cash-out refinances are always larger than the existing loan. That way, the homeowner can replace the existing debt, and use the excess capital to tap into the equity their home has managed to build.
In order to qualify for a cash-out refinance, homeowners typically need to have already built up equity, often times as much as 20 percent to qualify. For a better idea of whether or not you will qualify, LendingTree has a useful cash-out refinance calculator that can help put things into perspective.
Tapping into the equity of a home will come at a price: namely, owners will be expected to pay interest for the life of the loan. And since most cash-out refinances are either 15 or 30 years, it’s in the best interest of borrowers to spend the money they receive wisely. Since the money does come at a cost (cash-out refinance rates will vary between borrowers), most would agree it’s best to spend the money with long-term purpose. Home renovations that actually contribute to the subject property’s value are a common reason for conducting a cash-out refinance, as well as freeing up money for a down payment on a cash-out refinance investment property.
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When properly executed and used for the right reasons, a cash-out refinance can go a long way in helping homeowners realize the capital they need in a relatively short period of time. That said, there are some important rules and tips to take into account. Here’s a list of some of the most important things you should keep in mind when considering a cash-out refinance.
The cash-out refinance vs home equity loan “conversation” remains a topic of debate, and for good reason: there are just enough similarities between the two options to confuse those that are less familiar with them. Perhaps more importantly, both cash-out refinances and home equity lines of credit (HELOCs) award qualifying homeowners the opportunity to convert the equity they have managed to build in their own home into cash. However, unlike a cash-out refinance, HELOCs operate a lot like a credit card — the only difference being, the house is the collateral.
According to Investopedia, “lenders place a second lien on your home, giving them the right to eventually take over your home if you fail to make payments. The more you borrow against your house or condo, the more you’re putting yourself at risk.”
Home equity lines of credit tap into equity to give borrowers a credit limit, but funds are typically only dispersed upon request. As a result, you may borrow as much as you like, whenever you like (up to a certain limit, of course). More importantly, you will only make payments on the amount that has been taken out. A cash-out refinance, on the other hand, will have borrowers paying the entire amount over the course of the loan, plus higher closing costs. Home equity lines of credit don’t usually come with closing costs, and if they do, they are almost always less than cash-out refinances.
While a cash-out refinance and a home equity line of credit may sound similar, their differences are worth noting. That said, each has its use, but you need to be careful you are using it correctly. Home equity lines of credit, for example, are typically better left for shorter-term acquisitions. Buying a car or consolidating credit card debt, for example, are a great way to look into spending your HELOC, but the same can’t be said about a cash-out refinance. More importantly, it takes longer to pay off a cash-out refinance, upwards of 30 year, not the least of which you will be paying interest on for the life of the loan. As a result, cash-out refinances should be applied to long-term purchases that could potentially serve as an investment. Most people us cash-out refinances to improve their current home, or eve to buy a new one. Either way, the money is viewed as an investment; one that could potentially offset the interest that is being payed out.
Are you wondering whether or not a cash-out refinance is the answer to your cash needs? Let us know what your favorite way of tapping into a home’s equity in the comments below.