Understanding Cash-Out Refinancing & When It's Appropriate
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.
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. Estimate your spending and savings to understand how a cash-out loan can impact your overall long-term finances.
5 Common Uses For Cash-Out Refinances
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.
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