Cash-Out Refinance: Is It The Best Way To Access The Value of Your Home? | NerdWallet

If you need significant funds for a major project, like putting an addition on your home, a cash out refinance might be one of the first ideas that comes to mind for how to get your hands on that much money. But it might not be the best option and it's important to explore everything that's available to you. So today we are going to talk about the ins and outs of cash out refinancing, what it is, how it works, the pros and cons, so that you can decide whether a cash out refinance is right for you. As with any refinance, with a cash out refinance you are starting over with a brand new home loan. Your interest rate is going to change whether you like it or not. We'll talk a little bit more about that in a minute. Your term or how long the loan lasts also usually changes as well. Since it's about to be a larger loan, a lot of people will opt to start over with a new 30-year mortgage. The amount of the loan is really the biggest change with a cash out refinance. With a cash out refinance you're going to take out a new mortgage that's for more than you owe on the home. The difference between the size of the new loan and the amount that you still owe on your mortgage is where the cash out comes from. Let's use an example to see how it works. Say you own a home and its current market value is $400,000. And to make things simple, let's say you still owe $200,000 on your mortgage. That means you've also got $200,000 in home equity, the part of the home that you own. Your home equity is the value of your home minus the amount you still owe on the mortgage, that's the part that's an asset. So again, in this case, $400,000 home, you owe $200,000, you've got $200,000 in equity. In a cash out refinance, lenders will usually let you borrow up to 80% of your home's value. Sometimes you can borrow more, but in general, they want you to keep at least a 20% stake in the home. So to see the maximum equity you can borrow, multiply your home's value by 0.8%. In this example, the home's worth $400,000, so you could borrow up to But remember that you don't have access to all of that money. There's still the $200,000 that you owe on the mortgage. So subtract the amount you owe on the mortgage from the total amount you could borrow to see how much cash you actually can borrow. With this example, $320,000 minus the $200,000 you owe on the mortgage would give you $120,000 that you could borrow. That's exciting. That sounds like a lot of money. But remember to get at that cash, you are now taking on a new $320,000 mortgage. Let's go over the pros and cons of cash out refinances. We've already talked about the obvious pro that it is a relatively straightforward way to access a large amount of funds to turn some of your home equity into liquid cash that you can use for other things. There are other pros as well. For one, with a cash out refinance, you're still keeping things simple because you're just dealing with the one mortgage. You're not getting a new bill that you have to deal with paying every month. It's just the one loan. If you're in a specific life situation where you need money and you also need to make changes to your mortgage, divorce is the most obvious example, a cash out refinance might be helpful. You would need to refinance anyway to get your former spouse's name off of the titles of the home. And if in this example, you were buying them out of the house, you could use the proceeds from the cash out refinance in order to do that. Another is that in a falling rates environment, if mortgage rates have gone down from what they were when you initially got your loan, even though you're getting a new bigger loan, your mortgage payments might not be that hugely different because the interest rate is lower than the one you started out with. But that's specific to an environment where mortgage rates are going down and they're significantly lower than the original rate that you started with. Now let's talk about some of the cons of getting a cash out refinance. We were just talking about what would happen if interest rates were significantly lower than when you got your original loan. But what if interest rates have gone up since you got your original mortgage? For a lot of people, that's the case because so many people bought or refinanced when interest rates were at historic lows a couple of years back. Getting a cash out refinance with higher interest rates can potentially mean significantly higher payments because again, it's a bigger loan than your original loan. Even if you're spreading it out over a long time, your monthly mortgage payment might be higher. Cash out refinances also come with closing costs. They're usually between 2% and 6% of the total loan amount, so that's more money that you'll have to deal with. You might have heard of no closing cost refinances, but just like there's no free lunch, there is no actual no closing cost refinance. If a lender is offering you something like that, their costs are being built in somewhere else, usually in the interest rate that you're being offered. You can potentially roll your refinancing closing costs into the amount of a loan, but then you're paying interest on the closing costs, so that's just a bunch more money. Refinancing also takes time. If you are in a situation where you need money really quickly, like let's say your roof is leaking, moisture is getting in your house, you need a new roof immediately. A cash out refinance probably isn't your best option because you have to go through underwriting, you have to get an appraisal, all that stuff takes time. If you are in a time urgent situation, a cash out refi might not be the best option for you. Last, it's important to remember that your home is the collateral for the loan. That is true with any mortgage. That's true with your primary mortgage. Your home is always the collateral for the loan, but because you are potentially taking on higher mortgage payments, you really need to be sure that you're going to be able to afford those moving forward. That's one of the reasons why most people don't recommend a cash out refinance unless you're doing something with the money that puts value back in the home. Something like a renovation, an addition, something where you're improving the home, you're adding value, you're growing that equity that you borrowed right back. If you're thinking that all sounds a lot less good than it did a couple of minutes ago, let's talk about some alternatives to cash out refinances because there are other ways to borrow against your home's equity. One is with a home equity loan. With this, it's a simple loan. You're just borrowing a lump sum and you're repaying it over a set period of time. Home equity lines of credit are another option. These are more commonly called HELOCs. They give you a flexible line of credit that you can draw from as you need for a period of time, and then you go into repayment. HELOCs can be a little bit complicated, but luckily we've got a whole video about them. Both home equity loans and HELOCs are types of second mortgages, so that means they are completely separate from your primary home that original loan that you bought the house with or that you're paying your mortgage down on. That can be a really good thing if you are very attached to the interest rate that you have on your current mortgage. Because the home equity loan or HELOC is a separate loan, it has its own interest rate and you do not have to touch the interest rate on your primary mortgage. That said, second mortgages do tend to come with higher interest rates in general. That's because lenders consider them to be a little bit more risky. A lender's way of thinking about this is that were you to get into some kind of financial trouble, you're having difficulty paying your bills, that the second mortgage would be more likely to take the hit than your primary mortgage. So lenders will generally reflect that idea about risk in the interest rate that's offered to you. That can also mean that home equity loans and home equity lines of credit can be a little bit more difficult to qualify for than a cash out refinance, simply because they are second mortgages rather than taking out a whole new primary mortgage. Home equity loans and home equity lines of credit do come with closing costs, but they're generally less than what you'd pay for a refinance. Okay, so knowing all that, is a cash out refinance a good idea? It depends. If you're going to get a better interest rate, this could be a win-win. But if you're going to end up spending a lot of money in closing costs and interests, a cash out refinance might not be worth it. If you're planning on using the money to build up your home's value, a cash out refinance could be a good investment. You're adding to the equity you've borrowed against and upping your future resale value. But if you're looking for cash for something like a vacation, a wedding, or to deal with other debt, remember your home is the collateral for this new larger loan that you're now spending on something that's not giving you a return. That's kind of a lot of risk. One other thing to note, if you aren't actually looking to borrow that much money, you might not need to turn to your home equity at all. A personal loan or even a credit card could be enough to help you get the job done. But if you are looking for a substantial amount of money for a big project you're considering borrowing against your equity, it may be worth it to talk to a financial advisor. They can help you weigh your different options and look at the pros and cons. Yes, that is a little bit more money to spend to be able to talk to them, but if they're able to help you come up with a smart plan, that money could be well worth it. I'm Kate Wood, Editor-at-Above Mortgages and Home Buying for NerdWallet. If you want to learn more about cash out refinances or your other options, head to our site. But while you're here, like and subscribe for more.