Homeowners who have accumulated enough equity in their homes may be able to tap into that equity with a cash-out refinance to get money for a myriad of reasons. A cash-out refinance is when you refinance the balance on your existing loan with a larger loan, so that you receive cash back from the lender in addition to paying off the old loan.
The money you receive after finalizing the refinance with cash out can be used for almost anything, including buying a vacation home, paying for college tuition or medical bills. But beware that the money you get with a cash-out refinance is not free cash. It’s a loan that must be paid back with interest. Even when you refinance with a lower interest rate, it’s important to remember that the refinance will extend the duration of your loan and increase the total amount of interest paid.
Are You Ready For a Cash-Out Refi?
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How much equity do I have in my home?
A high loan-to-value ratio complicates things. To tap into your home’s equity, you need plenty of equity.
Types of Cash-Out Refinances
There are several types of loans to choose from for cash-out refinances. Remember that not all lenders offer all of these products. When you do your research and interview potential lenders, ask them which cash-out refinances they offer and what is their specialty.
These are loans that can be packaged and sold by lenders to mortgage giants Fannie Mae or Freddie Mac. These loans allow borrowers to roll closing costs, financing costs and prepaid items into the new loan amount. In addition, the Freddie Mac special purpose cash-out refinance mortgage allows borrowers in unique circumstances to use the cash they get from the refinance to buy out the equity of a co-owner. That could come in handy for a divorced couple whose names were both on the original mortgage. With the refinance, only one party takes responsibility for the mortgage.
- You must keep at least 20 percent of the equity in the home, meaning your total loan amount after the refinance cannot exceed 80 percent of the appraised value of your home.
- If you are refinancing with an adjustable loan, the loan amount limit is 75 percent of the home’s value. Before the housing and the mortgage crisis, Fannie and Freddie allowed cash-out of up to 85 percent.
- The agencies have minimum credit score and maximum debt-to-income ratio, or DTI, requirements. DTI is the comparison of your total monthly debt obligations to your pre-tax income. These depend on how much equity you have in the home.
The Federal Housing Administration (FHA) also offers a cash-out refinance. This loan requires more documentation than a simple FHA refinance mortgage because lenders view a cash-out refinance as a riskier type of loan. FHA requires the borrower to pay upfront mortgage insurance and annual mortgage insurance premiums unless 20 percent of the home’s equity is left intact.
- Your original home loan must be seasoned for one year. If the loan is less than one year old, you must keep 15 percent of the equity. The last 12 payments on the loan must have been made within the month they were due.
- The last 12 payments on the loan must have been made within the month they were due.
- You must have at least 5 percent equity in the home.
- Compared to conventional cash-out loans, FHA cash-out loans have looser rules for credit scores and for debt-to-income ratios to qualify. While there is no minimum credit score established by the FHA for cash out loans, lenders typically have their own requirements for credit scores. The minimum credit score for an FHA cash-out refinance loan can be as low as 620.
- You must provide at least two recent paycheck stubs, plus W-2 forms and federal income tax returns from the last two years.
Homeowners who are eligible for a Veterans Administration (VA) cash-out refinance can get up to 100 percent of their home’s value and pay no mortgage insurance premiums. The government guarantees these loans to service members and their families, which makes them much less expensive than refinancing with other programs. The VA cash-out refinance loan can be used to refinance a non-VA loan as well as a VA loan.
- The maximum loan amount is 90 percent of the home’s value, plus the cost of any energy efficiency improvements, plus a VA funding fee, according to HUD.
- You must have a valid Certificate of Eligibility from the government verifying their service background or connection to a military family member.
- You must provide evidence of sufficient income and good credit.
- You’ll need to show W-2 forms from the previous two years. Many VA lenders ask for copies of the two most recent federal income tax returns. While the VA does not have a minimum credit score, many lenders require a minimum credit score of 620 or more.
Additional Requirements to Qualify for a Cash-Out Refinance
Just as with any mortgage, you must meet all the requirements that lenders have set up for cash-out refinances. The more equity you have in your home, the more flexible lenders will be on credit requirements.
One of the most important aspects of a cash-out refinance is the loan-to-value (LTV) ratio, which is the total amount of the loan compared to the appraised valued of the home. That means an appraisal needs to be done to get the current value of your home.
To get started with a cash-out refinance loan, you can also talk with a certified financial planner or accountant to talk about the pros and cons of taking cash out of your home’s equity.
As with applying for a regular mortgage, you will need your bank, retirement and investment account statements, pay stubs and two W-2s or tax returns.
Wondering why cash-out refinances
require you to jump through so many hoops?
It’s because the loans were abused during the early 2000s. The cliché was that homeowners used the equity in their home like an ATM. Hence, when the mortgage crisis hit and home values plummeted, cash-out refinances disappeared. The equity was gone for many homeowners, so there was no equity to cash out. With new mortgage rules in place to protect lenders and borrowers, and with the value of homes bouncing back, cash-out loans are back. The allure is obvious: Interest rates remain historically low, allowing homeowners to grab a good rate while taking out cash to buy a vacation home, pay off medical bills or to invest in a new venture.
|BY THE NUMBERS: CASH-OUT REFIS|
Amount of equity borrowers cashed out in 2014 to pay off second mortgages
1 out of 5
Borrowers refinanced in 2014 to cash out equity
Amount of equity borrowers cashed out in 2014 for other purposes
9 out of 10
Borrowers refinanced in 2006 to cash out equity
|Source: Freddie Mac|
When Cash-Out Refis Make Sense
If you need money, a cash-out refinance can be the right strategy — for some people in the right situation. Assuming you can qualify for a favorable interest rate on this new loan, it might be a wise idea — especially if the maneuver improves your cash flow, adds value to your home or lets you jump on a great investment.
If you know that you will have income to pay back the new loan on time without putting your house at risk, then it might be time to talk with a financial professional to see if it’s a good idea.
With a cash-out loan, you are using the equity in your home. That equity can be looked at as a savings account for the future or for your retirement. If you vaporize all that equity with a cash-out refinance, your lose the potential cushion you have in case of a financial emergency. Once the equity disappears, you can’t get approved for a home-equity line of credit to pay for emergencies. And by reducing your equity, you will receive a smaller payday if you sell your house before that equity has had time to grow or you have paid off the new refinance loan.
5 Common Uses For Cash-Out Refinances
By taking some of the equity you have built in your home to repair or improve parts of your home, you can possibly help keep some equity in it or even grow that equity. For instance, the 2015 Cost vs. Value Report from Remodeling Magazine shows that if you used your cash-out refi for a minor kitchen remodel that costs $19,226, you can recoup 79.3 percent of your costs right away if you sell the house. Make sure the improvement you are making increases the value of your house in the long run. After all, a cash-out refi poses risk to you. Adding a hot tub or swimming pool might not justify your investment.
Instead of opting for a cash-out refinance, you might want to consider a home-equity line or a personal loan for smaller remodeling projects. This way, the loan is for a shorter term. Closing costs are a disadvantage to a cash-out refi, but you don’t pay closing costs on a home-equity loan. Figure out what make sense. Talking to a financial planner or certified public accountant about your options can help you understand the good, bad and ugly of a cash-out refinance.
High-rate debt? Bad. Low-rate debt? Better. That’s the way to think about trading credit card debt for mortgage debt. Using a cash-out refi to erase credit card debt can be a savvy move. But remember, those lattes and movie tickets and dinners out haven’t disappeared from your balance sheet; you still have to pay for them. They are just now included in your new refinanced mortgage, and you’ll be paying them off a long time. Yes, the interest rate on a refinance with a cash-out loan is much cheaper than those high-interest credit cards. In fact, the national rate for new credit cards is about 15 percent, according to CreditCards.com’s weekly credit card report. Interest rates on mortgage loans can be less than one-third to one-fourth of that rate.
Another advantage: Unlike credit card interest, mortgage interest is tax-deductible. So when you compare the difference between a low rate on a cash-out refinance loan to high credit card interest rates, it seems like a done deal. But is a new mortgage with cash-out the best choice for you? The answer would be no if you just plan on maxing out your paid-off cards again. Financial experts say that you need to get a whole new mindset once you pay off those cards. Learning willpower and better decision-making skills about credit necessary, or you will fall right back into the same situation. If you continue to carry hefty debt that strains your monthly cash flow, that puts your home at risk.
Once you convert credit card debt (which is unsecured debt) into a mortgage debt (which is secured debt), you’re putting your home on the line. By definition, unsecured debt has no collateral, while secured debt is backed by collateral. By putting your credit card debt in your cash-out loan, the house becomes the collateral, and you can lose it to foreclosure if you cannot make your house payments. Plus, once you add your credit card debt to your refinanced loan, you will be paying on those credit cards for the entire term of your mortgage loan — which could be up to 30 years. A financial adviser can help you figure out if other alternatives to cash-out refinance loan would be better in the long run — including such things as debt settlement and debt consolidation.
Also, according to Fannie Mae, some mortgages will require that you show that you paid off the cards, depending on how you were qualified. This mainly applies when your DTI is too high to qualify. The lender calculates your DTI without the credit card debt, under the assumption that you will pay off the card at closing. In fact, Fannie Mae stipulates that if a revolving account is to be paid and closed with the cash received in the refinance, then then the monthly payment on the outstanding debt will not be included in the DTI.
It would be nice to have just one mortgage to pay each month. You’ve been paying your second mortgage and/or your equity line of credit payments along with your original mortgage. By getting a cash-out refinance to pay those other mortgages off, you might have better cash flow, depending on what interest rate you receive and how much you need to take out in cash from your refinance. But remember that on a cash-out refinance, you must pay closing costs. Those costs can add up into the thousands depending on your mortgage. Even if the closing costs can be rolled into your cash-out refi, you will have to pay it — just for a longer period of time. Another thing to consider is how close you are to paying off your original mortgage. If it is a new loan and the interest rate is less than what the refinance interest rate will be (or it’s an adjustable rate), then a cash-out refinance could be the answer.
Are you an expert stock picker? If you could make 10 percent to 20 percent on an investment and you are only going to pay 4 percent for the interest on a cash-out refinance, why wouldn’t you do it? Well, first you have to figure out if that investment truly will pay off. There are no guarantees. But research the investment and see if it fits into your financial plan for the future.
Some people use the cash-out refi to get enough money for a down payment on a second property that they can make into a rental for an investment. It is cheaper money than taking out a home equity loan or borrowing from your 401(k) retirement plan. Others want to put down a down payment on their dream vacation home. It could be that beach house or a mountain cabin. Wherever it may be, you feel that it is time to splurge on something you’ve always wanted. Adding to your quality of life is priceless — but there is a price to getting a cash-out refinance. You do have to pay it back every month, and the equity in your home is now depleted.
Your child means the world to you, and for some reason, you just haven’t put enough in a savings plan for college tuition. Plus, he needs a car to get back and forth to his classes. You figure a cash-out refinance mortgage could solve those problems and help your kid out at the same time. He won’t have to take student loans and worry about paying them back in the future. Well, someone is going to pay for all this, and it will be you. There might be better and less risky ways to get that cash for tuition, buy a car or pay for other big-ticket items.
A home equity line of credit might be the answer. You can pull money out of it when you need it — like each semester for his college tuition. You can get the money quickly without refinancing your entire original mortgage, and you won’t have to pay hefty closing costs. But home equity loans still put your home at risk if you default. You can also help your child to fill out the Free Application for Federal Student Aid (FAFSA). You can’t receive financial aid at a college unless you apply. And remember that if your child does take out federal student loans, these offer a few protections if borrowers run into trouble paying them off in the future, according to Federal Student Aid, an office of the U.S. Department of Education. If you pay the tuition with a cash-out refinance, those protections go away. Plus, if you really need to buy a car, check out all low-interest rate offers, including 0 percent rates, at car dealerships these days. Paying for a car loan for 5 years might work to your advantage compared to adding it in to your mortgage and paying for it the entire 15 to 30 years.
Should I Get a Cash-Out Refinance to Pay Off Credit Cards?
Say you borrowed $200,000 with a 30-year fixed-rate mortgage at 5 percent in May 2010. Your monthly principal-and-interest payment is $1,074.
You’ve got $20,000 in credit card debt at 18 percent interest. You pay only the interest each month. Your monthly payment is $300.
It’s May 2015, and your loan balance has fallen to roughly $184,000. You borrow $207,000 (enough to pay off the $184,000 balance, plus $3,000 in closing costs, plus $20,000 to get rid of your credit card balance) at 4 percent for 30 years. Your new monthly payment: $988.
Why Cash-Out Refinances Must Be Used Wisely
During the housing bubble, home prices skyrocketed, allowing homeowners to use this explosive equity to their advantage — well, at least they thought it was to their advantage. Many treated that equity like a piggy bank and kept taking out big chunks of cash. Even if homeowners used their sudden wealth to buy boats, jewelry, expensive trips, swimming pools and cars, lenders obliged their requests willingly.
When the housing market collapsed in 2008, many of those equity-draining homeowners lost their houses to foreclosure and short sales. Federal Reserve Board researcher Steven Laufer studied the subject and reported that a lot of the mortgage crisis can be blamed on cash-out refinancing. When home values began to plummet, the homeowners who withdrew equity from their homes over and over again to live beyond their means found themselves with an underwater mortgage — meaning they owed more on the home than it was worth.
Even though stricter rules have been put into place for cash-out refinances, homeowners still must be prudent, smart and informed before deciding on taking out equity. It can be a great asset, but also the start of a financial fiasco if not done properly. Always talk with a financial professional before taking a big step like this that could change your financial snapshot.
Cash-Out Refinance Volume Over the Years
The number of cash-out refinances peaked in 2006, during the housing boom, which was followed by the foreclosure crisis.
ANNUAL CASH-OUT VOLUME FOR ALL PRIME CONVENTIONAL LOANS
Cash-Out Refinance Questions & Answers
Melinda Opperman, a certified housing counselor with Springboard Nonprofit Consumer Credit Management, answers our questions about cash-out refinances.
Is a cash-out refinance a sound financial tool?
It’s great for lenders. They are very interested in persuading borrowers to use this option, because it renews debt for more years and keeps the borrower paying interest for longer. For the borrower, it can be good to refinance and get a better interest rate, but when one takes cash out at the time of refinancing, the risks are great, and the money taken out often goes toward purposes that aren’t worth incurring a new lifetime debt for.
Who would be a good candidate for a cash-out refinance and why?
Someone with a life-or-death situation who needs to access the equity in their home but doesn’t want to sell their house might consider a cash-out refinance. They should also consider every other option available to them before making a decision. Cash-out refi only makes sense if the new mortgage rate is significantly lower, the borrower is going to stay in the house for many years to come, and the money they are taking out is truly essential and they can’t get it any other way. Using this option to pay for something like a vacation is completely irresponsible, and there are usually better options for things like dealing with credit card debts and student loans.
When should you stay away from a cash-out refinance? Why?
If you have any other option, consider it before a cash-out refinance. A cash-out refi puts your home at risk and sets you back to the beginning of a new mortgage loan, with more debt to carry. I can’t stress enough the risks of this strategy; even if you are forced to declare bankruptcy for some reason, you can protect your home in the bankruptcy proceedings. That cannot be said for most of the other uses for your home equity.
What are some of the red flags when you are getting a cash-out refinance?
If your new mortgage is represents more than 80 percent of the home’s value, you’ll be subject to PMI (private mortgage insurance), and that means extra costs every month. PMI protects the lender, not you. Also look out for high closing costs. If you have to pay thousands of dollars just to get the refinance, it will be years before you see any financial benefit.
What is the biggest misconception about cash-out refinances?
For decades, conventional wisdom said that property values would always rise. The last 10 years have taught us that this isn’t true, and when one refinances a home, they put their property ownership at risk when a bubble bursts and values drop. We always counsel people to protect their home first — pay the rent or mortgage every month before any other debt, because having a roof over your head is the most important thing. Cash-out refinancing is the opposite of this principle. Even savvy people who think they can take cash out of their home equity and invest it wisely are making a mistake — you can’t live in a stock certificate.
Can you describe a scenario of someone that you worked who had gotten into financial trouble because of a cash-out refinance?
We saw countless examples in the run-up to the housing crisis. Around the turn of the century, many people were cashing out home equity to pay down credit card debt. We counseled people against this at the time. But home values had never been higher, so refinancing became a very popular way to pay down revolving debt. Unfortunately, when the housing market nearly collapsed, a lot of people were left with more mortgage debt than they could afford, owing more than their homes were truly worth. They turned unsecured debt into secured debt, and jeopardized their home. They created a much bigger problem for themselves when they borrowed against their home values and put their mortgages at risk of foreclosure.
On top of all that, refinancing to pay down credit cards turned out to be a temporary solution. Those borrowers who didn’t address the root causes of their debt problems went on to run up credit card debt again, and there was no quick refinance option to bail them out the second time.
When could a cash-out refinance be beneficial financially?
It’s only in very rare and specific cases that one would truly benefit financially. Taking cash out of one’s home to invest is risky, and when the consequences of that risk can be foreclosure, it’s simply not worth it. The crucial thing is to do the math carefully — or have a certified housing counselor help you with it. If you are refinancing in a way that saves you significant money on your mortgage rate, and you have enough years left on your mortgage that the savings will be much greater than the closing costs of your refi, then you have to consider what the cash you’re taking out is doing for you. If that money is going to be used to improve your home in a way that will definitely improve the home’s value, it might make sense. But if you’re not getting a significantly better rate, and the plans you have for the money are risky or wasteful, then it’s not a good idea. Even something like paying for college, which is traditionally considered “good debt,” is not a great use for cash-out refinancing. Few loans have terms as good as student loans — they’re easy to defer, for example. There are no deferments for mortgage debt. A student loan is a better vehicle for paying for college than risking your house.