Cash-out refinance: An explanation of its nature and operation
A cash-out refinance is a popular financial tool that allows homeowners to replace their current mortgage with a new, larger one, receiving cash from the difference between the two loans. This article explores the benefits and drawbacks of cash-out refinances, comparing them to alternative financing options like HELOCs, home equity loans, personal loans, and reverse mortgages.
Benefits of Cash-Out Refinance
One of the main advantages of a cash-out refinance is that it typically offers lower interest rates than HELOCs, home equity loans, or personal loans because it replaces your primary mortgage and benefits from mortgage rates, which are generally lower than unsecured or second mortgage rates. Additionally, a cash-out refinance simplifies finances by replacing the existing mortgage, resulting in a single monthly payment.
Another benefit is the ability to borrow larger amounts, making it suitable for major expenses like home renovations or college tuition. Cash-out refinances can also be used for debt consolidation, potentially saving on interest and improving credit scores by lowering credit utilization. Furthermore, cash-out refinances offer flexible options with fixed or adjustable rates and mortgage terms typically from 15 to 30 years.
Drawbacks of Cash-Out Refinance
Despite its advantages, a cash-out refinance also comes with certain drawbacks. Higher closing costs, typically ranging from 2% to 5% of the loan amount, can make it more expensive than HELOCs or home equity loans. Cash-out refinances also extend mortgage debt, potentially increasing total interest paid over time.
Moreover, cash-out refinances usually require at least 20% equity in the home; if less, mortgage insurance might be required, adding cost. Since the home serves as collateral, failure to make payments could lead to foreclosure. Lastly, rates on cash-out refinances can be higher than on a refinancing without cash out, so if you don't need cash, a rate-and-term refinance may be a better option.
Comparison to Alternatives
| Feature | Cash-Out Refinance | HELOC | Home Equity Loan | Personal Loan | Reverse Mortgage | |----------------------------|----------------------------------------------------|---------------------------------------------------|-------------------------------------------------|--------------------------------------|--------------------------------------------------| | Loan Type | First mortgage replacement | Revolving line of credit (second mortgage) | Fixed second mortgage | Unsecured loan | Loan for seniors secured by home | | Interest Rate | Generally lowest; fixed or adjustable | Variable usually, lower than unsecured | Fixed, higher than mortgage | Higher (unsecured) | Variable or fixed | | Loan Amount | Large sums, up to most equity available | Limited to credit limit, aggressive access | Lump sum; usually less than cash-out refi | Often smaller than home equity loans | Depends on home value, age, and loan terms | | Repayment Terms | 15-30 years, principal & interest | Interest only draws, then 10-20 years principal + interest | 5-30 years, principal & interest | Shorter terms | No monthly repayments required (repay on move/sale) | | Closing Costs/Fees | 2%-5% of loan amount, higher than alternatives | Lower than home equity loan and cash-out | 1%-5% of loan amount | Usually none or small fees | High upfront and ongoing fees | | Best Use | Large expenses, debt consolidation, refinancing | Ongoing or uncertain needs, flexible access | Fixed amount known upfront | Small expenses or debt consolidation | Seniors needing income or no monthly mortgage | | Risk | Foreclosure if default | Foreclosure risk | Foreclosure risk | No collateral risk | Home equity depletion risks to heirs |
Key considerations compared to other options:
- HELOC: More flexible access to funds over time but usually variable rates and possible payment shocks after draw period; generally lower upfront costs.
- Home Equity Loan: Fixed rate and payments, good if you know the exact amount needed; less costly upfront than cash-out refinance but higher rates than mortgage rates.
- Personal Loan: Easier and faster to obtain with no home as collateral, but much higher interest rates and smaller loan amounts.
- Reverse Mortgage: Only eligible for seniors; no monthly payments but reduces inheritance and has higher fees compared to cash-out refinance; useful if you need income rather than a lump sum.
In summary, a cash-out refinance is most beneficial if you want a large lump sum at a relatively low interest rate, prefer a single mortgage payment, and are comfortable extending your mortgage debt. However, it comes with higher upfront costs and risks related to foreclosure. Alternatives like HELOCs and home equity loans offer more flexibility or fixed payments but often at higher rates or with less total borrowing capacity. Personal loans are less costly upfront but expensive in interest, and reverse mortgages suit a specific senior population needing ongoing income rather than a lump sum.
Choosing among these depends on your financial goals, equity, credit profile, risk tolerance, and how you plan to use the funds. If you use your equity to consolidate debt, your credit utilization ratio could drop, potentially helping to boost your credit score. Cash-out refinance can be used for any purpose, including home remodeling, debt consolidation, college tuition, and other financial needs.
Conventional cash-out refis typically come with a six-month seasoning requirement, meaning the home must be owned for at least six months. The terms of a refinanced mortgage might significantly differ from the original loan, including a new rate and a longer or shorter duration. Tapping home equity to pay for college can make sense if the refinance rate is lower than the rate for a student loan. Refinance rates tend to be lower compared to other forms of debt, such as credit cards, making it possible to use a cash-out refinance for high-interest debt consolidation.
If mortgage rates have decreased since you first took out your loan, or your credit has improved - or both - you may be able to get a lower rate when you refinance, making a cash-out refinance more attractive. Many borrowers use the proceeds from a cash-out refinance for home improvement projects. A cash-out refinance requires maintaining at least 20 percent equity in the home. A home equity loan is a second mortgage that provides a lump-sum payment with a fixed rate and immediate repayment. A home equity line of credit (HELOC) allows you to borrow money when you need to with a revolving line of credit, similar to a credit card. With a conventional cash-out refinance, one can typically borrow up to 80 percent of the home's value, but this threshold varies depending on the property type. The new loan will be for a larger amount, including cash withdrawn from the home's equity. To secure a cash-out refi, one must determine how much can be withdrawn, figure out goals, shop around for the best terms, and go through the application and underwriting process. To qualify for a cash-out refinance, one needs to have a credit score of at least 620, a debt-to-income ratio usually capped at 43 percent, and equity of at least 20 percent in the home.
[1] https://www.nerdwallet.com/blog/loans/refinance/cash-out-refinance/ [2] https://www.fairwayindependent.com/blog/cash-out-refinance-everything-you-need-to-know/ [3] https://www.investopedia.com/terms/c/cash-out-refinance.asp [4] https://www.lendingtree.com/home/refinance/cash-out-refinance/ [5] https://www.bankrate.com/mortgages/heloc-vs-home-equity-loan/
- The cash-out refinance is beneficial for homeowners seeking a large lump sum at relatively low interest rates, as it often offers lower rates than home equity loans, HELOCs, or personal loans due to mortgage rates.
- If you prefer a single mortgage payment and are comfortable extending mortgage debt, a cash-out refinance can be a suitable option, despite higher upfront costs and the risk of foreclosure.
- Cash-out refinances can be used for a variety of purposes, including home remodeling, debt consolidation, college tuition, and other financial needs. Homeowners must have at least 20 percent equity in the home to qualify and may need to maintain this threshold to secure the refinance.
