How Does a Cash-Out Refinance Work?

how does a cash out refinance work

More than 1.3 million Americans refinanced their homes in the first three months of 2020, marking a seven-year high. There are times in all our lives when we could do with extra cash. From waving a child off to college to finally building that home extension, raising additional capital can be hard work. A cash-out refinance on a loan or mortgage can provide you with the money you need, but just how does a cash-out refinance actually work?

What is a Cash-Out Refinance?

A cash-out refinance allows you to borrow a sum of money, at the same time as refinancing your mortgage. Put simply, refinancing replaces your old mortgage with a new one, ideally with better terms. If you took out a mortgage five years ago with a 4.5% interest rate, a new mortgage agreement could see you paying 3% instead. With a cash-out refinance, you’ll have these same potential benefits, plus the opportunity to borrow a sum of money. You’ll receive a check for the amount you want to borrow, but your mortgage repayments will increase to cover the cost of the amount of your loan—as well any closing fees.

Lenders vary on how much they’ll lend you, but generally, you won’t be able to borrow more than 80 percent of your home’s value.

When Does a Cash-Out Refinance Make Sense?

There are many reasons that people choose to use a cash-out refinance. They can come in handy for paying off debts or getting a business off the ground. You can use the money you draw out for any purpose you like, but should be aware that there may be tax consequences on certain uses.

You May End Up With Better Rates

A major draw of a cash-out refinance is that the interest rates are often lower than with other types of loans. So if you have substantial debts on credit cards or with high-interest loans, you are likely to end up paying less in interest over time.

Depending on when you took out your mortgage, you could also end up with an improved rate after a cash-out refinance. For example, if you bought your home when market rates were high, a cash-out refinance could help you secure an improved rate, as well as borrow a chunk of money.

You Can Renegotiate the Length of the Loan

Another perk can be the length of time you have to repay what you owe. Many loans have a cap of 5 or 10 years to bring the balance to zero, whereas mortgages can often be repaid over the course of 30 years, giving you a cushion of extra time to spread the cost.

What You Should Know About Cash-Out Refinances

A cash-out refinance is definitely not the best option for everyone. You’ll be liable to pay closing costs of 3% to 6% on the total loan amount, which means that if you have a remaining balance of $200,000 on your mortgage and you borrow an extra $50,000, you’ll be paying 3% to 6% of a total of $250,000. There’ll also be costs such as origination fees, closing costs and appraisal fees.

For people wishing to borrow a large sum, cash-out refinances can be a good option. But if you only need a smaller loan, you may well be better off with a line of credit or a home equity loan. It’s important to remember that you are also at risk of foreclosure if you end up not being able to pay your monthly repayments. If your monthly payments increase after refinancing, carefully consider whether the chunk of cash you withdraw is worth the financial burden.

Do You Have to Pay Taxes on a Cash-Out Refinance?

The IRS doesn’t count the money you cash out as income, so you won’t be liable to pay income taxes. If you use what you borrow to make home improvements, you may be liable for a tax deduction by deducting your monthly mortgage repayments from your taxes. Make sure you check with a tax professional before undertaking any projects.

How Your Credit Score Affects a Cash-Out Refinance

Your loan provider will want to know that you can manage your new repayments, so you’ll need to show you’ve got income coming in and that your credit score is decent. SmartCredit can help you take control of your future score with a range of easy to use tools. With ScoreBuilder*, you can take action on a negative account with a 120-day plan, while ScoreTracker gives you insight into your score fluctuations over time, as well as the sorts of scores available to you.

*This feature unlocks if you have negative credit data.

 

References

  1. https://www.forbes.com/sites/advisor/2020/07/06/record-low-mortgage-rates-stoke-hot-refinance-market-heres-how-to-take-advantage/#7c8621c82ce7
  2. https://www.businessinsider.com/personal-finance/cash-out-refinance?r=US&IR=T
  3. https://www.investopedia.com/mortgage/refinance/when-and-when-not-to-refinance-mortgage/
  4. https://us.cnn.com/2020/08/10/cnn-underscored/cash-out-refinance-pros-and-cons/index.html/

 

 

 

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