While cash-out refinances are an excellent option for many homeowners, understanding exactly how it works is your first step into seeing if this transaction is right for you.
Cash-Out Refinances: The Basics
In short, a cash-out refinance replaces your existing home loan with a new mortgage that is greater than what you currently owe. You'll receive the difference between your old mortgage and your new one in cash. While you're free to spend this cash as you please, the two most common reasons that homeowners pull equity out of their homes is to cover the cost of home improvement projects, or to pay down high-interest rate credit cards.
For example, let's say you bought your home for $300,000 several years ago. Your monthly payments have brought the principal on your mortgage down to $200,000; at the same time, an appraisal demonstrates that the value of your home has increased to $400,000. Most lenders cap the amount you can take out for a cash-out refinance at 80 percent of your home's value and not necessarily what you’ve paid for it. In this case, that means you'd be able to take out a mortgage for $320,000, letting you "cash out" the remaining $120,000 difference.
The 5 Main Benefits of a Cash-Out Refinance
The ability to obtain a significant portion of your home's equity in cash combined with market-level interest rates means that cash-out refinances can provide homeowners with several major advantages:
1. Your interest rates could potentially be lower than with the alternatives.
Because they offer mortgage-level interest rates, most cash-out refinances will have lower interest rates than a home equity line of credit (HELOC) or a home equity loan (HEL) can offer. If you're looking to lower your monthly payment while accessing some equity you’ve built, a cash-out refinance could help.
2. You have the opportunity to consolidate debt.
Interest rates for cash-out refinances are much lower than for credit cards. That means that you stand to save thousands upon thousands of dollars in interest by consolidating high-interest credit card debt with the funds obtained through a cash-refinance.
3. You can improve your credit score dramatically.
Using the cash from a cash-out refinance to pay off credit card debt will lower the amount of available credit you're using (known as your credit utilization ratio). Doing so can provide a huge boost to your credit score.
4. You can boost the value of your home even further.
You have the opportunity to take out a cash-out refinance because the equity in your home has grown. If you turn around and put that money back into your home in the form of home improvements, you stand to increase the value of your home and your equity in it even further.
5. You may be able to take a larger deduction on your taxes.
Credit card interest isn't tax deductible, but mortgage interest payments are. Consolidating your debt through a cash-out refinance can thus lead to a larger tax refund.
Always keep in mind that your home is on the line when considering a cash-out refinance so, don't take on more than you can afford to pay for. After doing your research and working with a mortgage professional, a cash-out refinance is often a great option for those who are looking to making significant home renovations or who are committed to healthier financial habits.