A cash-out refinance replaces your existing mortgage with a new home loan. The new home loan is for more than you owe on your house and the difference goes to you in cash. You must have equity built up in your house to use a cash-out refinance. Refinancing your mortgage can also be a good way to reduce your loan’s interest rate. If you need to consolidate debt, make a large purchase, or pay off college expenses, a cash-out refinance may be a good choice to consider.
A cash-out refinance replaces your existing mortgage with a new loan equivalent to your home’s current value, which should be more than what you presently owe on your house. That’s what sets it apart from traditional refinancing, which replaces your existing mortgage with a new one for the same balance, but a different interest rate. A cash-out refinance may also get you a better interest rate, and it may come with a lower interest rate than a home equity line of credit, or HELOC.
Once completed, you can spend this cash as you see fit, but it’s best to use it for expenses that give you a return on your money. Spending it to pay off credit card debt can improve your credit score and eliminate high-interest rates. While this is a great use for the money from your cash-out refinance, it is important you don’t run up your credit card balances again. Many homeowners use the cash for home improvements, which is often prudent because it improves the value of your home and helps rebuild the equity you took out for the refinancing. In addition, the home improvement expenses may qualify for a mortgage tax deduction. If you have a child that is considering student loans to pay for college, be sure to check their interest rates versus what you can obtain with a cash-out refinance. You may be able to help your student save substantial amounts of money and reduce their financial burdens down the road.
One thing to consider when calculating the benefits of a cash-out refinance is private mortgage insurance (PMI), which you will have to pay if you borrow more than 80% of your home’s value. For example, if your home is valued at $200,000 and you refinance for more than $160,000, PMI will probably be required. Private mortgage insurance typically costs from 0.55% to 2.25% of your loan amount each year. PMI of 1% on a $200,000 mortgage would cost $2,000 per year.
Refinance rates are based on your credit score, loan amount, zip code and other criteria. Because your credit score has a big impact on your rate, it’s important to review your credit report and correct any errors prior to refinancing. It’s not unusual to find a delinquent payment on your report for an account you’ve never had or thought that you’d closed. If your credit score is not where it needs to be, considering working on improving it before refinancing your home.
A cash-out refinance can make sense if you can get a good interest rate on the new loan and have a sound use for the money. We don’t recommend that you use this to fund vacations or buy a new car, because you’ll have no return on your money. By contrast, if you use the money to fund a home renovation, you’re rebuilding the equity. If you use it to consolidate debt, you put yourself in a much better financial position.