Cash-Out Refinance: What It Is And How It Works

Traditional refinancing entails swapping out your current debt, often a mortgage, for another loan with better terms. For example, many people choose to refinance their homes when housing market interest rates drop so they can pay less money in the long run.

What is a cash-out refinance, though? It’s a little different. Instead of trying to pay less, you borrow more than your house is worth and use the extra money for other debts, purchases, or payments.

How do you know if acquiring funds this way is right for you? If it is, when is the best time to do it? Let’s dive into why people choose to go through this process.

You might use a typical term-and-rate refinance to exchange your mortgage for one with lower monthly payments or another benefit. However, a cash-out refinance means you switch out your mortgage for a larger one.

Why would anyone want to borrow a bigger mortgage? It’s a way to access the value of your home that you own through a loan instead of selling it. If you have paid off any part of your mortgage, then you have built “equity.” You cannot use your home’s equity to make purchases in illiquid form, so taking out another loan and using your equity as collateral allows you to use that value as cash.

Next, how does a cash-out refinance work? Most lenders limit the amount you can cash out to between 80% and 90% of your property’s equity, so you cannot withdraw as much as you might hope.

Because you are borrowing against your equity, you need to have accumulated a sufficient amount (in other words, you have paid off a sizable portion of your mortgage). It’s also advisable to keep around (and sometimes required) 15-20% of your equity once the process is complete. For example, if your home is worth $400,000, you could take out another loan worth 80% of your home’s value, which is $320,000. How much money you have left to spend on other things depends on your mortgage balance. If you have $150,000 in equity and $250,000 left to pay, you would have $70,000 left over.

How you use your refinance money is up to you. Many people use their new cash to pay for:

Do you want to modernize your kitchen but can’t afford to? Do you want to go back to school but don’t want to burden yourself with high-interest student loans? While there are other options you should consider first, cash-out refinancing can provide you with the funds you need for significant expenses.

No, it is not strictly necessary for anyone to exchange their mortgages for a larger one and withdraw the difference. You might hear of your neighbors and friends refinancing their homes in the traditional sense because the market is optimal, but the cash-out variety is not a trend you need to jump on if you don’t need to.

People have different reasons to refinance their homes this way. Some might owe a wide variety of debts and want to consolidate. Others might have fallen on hard times and need a large sum of money as soon as possible, but they don’t have any other options than to sell their possessions if they don’t want to move. They cannot sell their equity, though, so the best option is to use it as collateral for another loan.

You might be considering cash-out refinancing because delays in receiving your paycheck have made you miss important payments. You had to dip into your savings, which you prefer not to do, but having larger savings from your home’s equity could be useful in the immediate future. Instead, you can turn to apps like Earnin that allow you to access your money on time, up to $500 per pay period. Instead of doing a cash-out refinance to borrow a large sum to pay off monthly bills, you can use Earnin to take out your own earnings.

There are several disadvantages to consider before you cash-out refinance. One of them is closing costs, which are typically between 2% and 5% of your loan and can, therefore, amount to thousands of dollars. Similar to how you must pay for private mortgage insurance if you put less than 20% when buying a house, you will have to pay for PMI if you borrow more than 80% of your property’s value.

Time is also an essential factor. It may take longer to pay off your house, and your monthly mortgage payment could increase. Though interest rates associated with this kind of refinancing may be lower than HELOCs or home equity loans, your lender might charge you a higher interest rate than the first time around.

Cash-out refinancing has its uses, but consider the pros and cons carefully and talk with a financial advisor before deciding it’s right for you.