Cash-Out Refinance: How It Works and When To Do It

For some time, lower mortgage rates have served as financial relief to homebuyers. Unfortunately, there are a few challenges that are contributing to changes in these trends and homebuyers are curious about their options. Most housing experts point to inflation and the Fed accelerating its asset-purchase tapering to be sure signs of higher mortgage rates.

The General Idea of Refinancing

Refinancing is a popular process for replacing an existing mortgage with a new one that typically extends terms to the borrower that are more favorable. By refinancing a mortgage, you may be able to decrease your monthly mortgage payments and perhaps negotiate a lower interest rate. 

What is a Cash-Out Refinance? 

A cash-out refinance is a mortgage-refinancing option in which an old mortgage is replaced by a new one with a larger amount owed on the previous existing loan. This ultimately helps borrowers use their home mortgage to get cash. When you opt for this option, you take out a new loan that’s bigger than your existing mortgage. The new loan amount is used to pay off your current home loan, and the remainder is returned to you as cash-back. 

The Pros and Cons of a Cash-Out Refinance

If you’re looking to reduce one of your largest expenses, refinancing your mortgage could be beneficial. Smart investors will typically jump at the chance to refinance when lending rates are falling to new lows. However, as there is a variety of refinancing options available, it would be beneficial to check the terms of your mortgage agreement. 

A cash-out refinance is one of the cheapest ways to get cash in terms of interest paid. However, it comes with the high risk of losing your home if you can’t keep up with increased mortgage payments or the value of your home goes down. 

This refinance option gives the borrower all of the benefits they are looking for from a standard refinancing, including a lower rate. 

How Much Can You Get From a Cash-Out Refinance?
Conventional Loans: With guidelines set by Fanny Mae and Freddy Mac, you’ll be able to borrow up to 80% of your home’s value with a minimum credit score of 620. Additionally, you won’t have to worry about mortgage insurance, which provides lenders with financial protection if you default on your home loan.

FHA Loans: Backed by the Federal Housing Administration (FHA), an FHA cash-out refinance allows you to borrow up to 80% of your home’s value with credit scores as low as 600. Here’s the catch: you’ll pay expensive FHA mortgage insurance regardless of how much equity you have, as well as upfront fees that are financed into the loan. 

VA Loans: Designed for eligible military borrowers, the U.S. Department of Veteran Affairs (VA) guarantees VA cash-out refinance loans up to 100% of a home’s value. You won’t pay mortgage insurance on a VA cash-out refinance. Instead, the VA charges a funding fee between 2.3% and 3.6% of your loan balance, unless you’re exempt because of a disability-related to your military service. 

Your current mortgage and qualifications will help you determine the right type of cash-out refinance option for your needs.

Keep In Mind: 

  • Cash-out refinance rates are slightly higher than traditional mortgage refinance rates. 
  • Your refinance rate depends on your credit profile and how much cash you take out. 
  • You can typically cash out up to 80% of your home equity. 
  • Your new loan will be larger than your old one, so you’ll pay more in mortgage interest in the long run. 
  • Since mortgage rates tend to be lower than personal loan or credit card rates, cash-out refinancing can be a better way to finance larger expenses. 

How Does a Cash-Out Refinance Affect Your Taxes?
Tax Rules for Cash-Out Refinances: You can deduct the interest you pay on your new mortgage from your taxable income if you use the cashed-out funds to make capital improvements on your home. Deduction-eligible projects generally include permanent additions and home improvements that increase your property’s value, extend its longevity, or adapt it for new uses. 

How to Use Your Cash-Out Refinance Money So It’s Tax-Deductible: There are plenty of home improvement projects that you can tackle with your cash-out in order to claim the mortgage interest deduction. 

  • Adding a swimming pool or hot tub to your backyard
  • Constructing a new bedroom or bathroom
  • Adding a fence around your home
  • Enhancing your roof to make it more effective in protecting against the elements
  • Upgrading windows 
  • Setting up a central air conditioning or heating system
  • Installing a home security system

Keep in mind that these sorts of improvements are supposed to increase the value of your home. Repairs such as fixing a broken window or painting a room don’t usually count. 

Do You Meet the Requirements? 

Your lender sets their own requirements when it comes to deciding who qualifies for a refinance. Some of the most common cash-out refinancing requirements include: 

  • A credit score of at least 620
  • A debt-to-income ratio of less than 43% 
  • More than 20% equity in your home
  • A new appraisal to verify your home’s value 
  • A loan-to-value ratio of 80% or less 
  • Verification of your income and employment

Is There Still Time to Refinance? 

As rates continue to rise, the number of borrowers refinancing their mortgages has diminished. With the rates rising again, many people who bought their homes in the past few years may not see the advantage of refinancing. 

However, while timing the market is already difficult, homeowners who can shave even the slightest bit off their interest rate by refinancing may want to make a move sooner rather than later. 

Due to closing costs running between two and five percent, you should plan on keeping your home long enough to cover closing costs and realize the savings from refinancing at a lower rate. 

Closing Thoughts

The window for yielding financial success from a cash-out refinance is becoming smaller and smaller. However, even with mortgage rates on the rise, the cash-out option may still be cheaper than other forms of borrowing like credit cards and personal loans. Borrowers who are looking to tap into their home’s equity for a cash-out refinance will probably be better off doing that now than waiting a few months since interest rates on those loans are likely to increase for the foreseeable future.