05 Oct What Does Cash-out Refinance Mean and How Does It Work?
If you’ve paid down your mortgage enough, you can get some money out of it with a cash-out refinance loan.
Home is where the heart is—and where your growing pile of equity lives. Every time you make your monthly mortgage payment, your home becomes a bigger financial asset. When you need some extra cash—whether it’s for a renovation, to pay off credit cards, or for anything else—you might consider tapping into your home equity for the funds. One of the ways to do that is with a cash-out refinance.
What is a cash-out refinance?
A cash-out refinance is a new loan that replaces your current mortgage, but for an amount higher than what you owe. The difference between the amount you owe and the amount of your loan is given to you in cash (thus the phrase “cash-out refinance”) in a lump sum. You can use the money as you see fit.
How does a cash-out refinance work?
To get a cash-out refinance, you first need to have built at least 20 percent equity in your home. (So if you’re a first-time homeowner who recently bought a house, this might not be for you.) You’d then shop around for a cash-out refinance loan, comparing rates with different banks. If approved, the new loan pays off your current mortgage—and the excess money is given to you after you close.
- Here’s how the math on a cash-out refinance works:
- A homeowner has a house worth $250,000.
- Their remaining mortgage balance is $100,000.
- The homeowner needs $30,000 for a renovation.
- The homeowner takes out a new loan for $130,000.
- They’ll get $30,000 cash after they close.
What are the pros of a cash-out refinance?
The main benefit of a cash-out refinance is access to a large amount of money that can otherwise be difficult to save. After all, you’re busy paying your mortgage. Plus, if you’re using the money to improve or remodel, you could potentially increase your home’s value. If you’re using the funds to pay off debt, you could save on interest charges and improve your credit score. Also, if your mortgage originated during a time when interest rates were high, a cash-out refinance might have a lower interest rate than your current mortgage.
What are the cons of a cash-out refinance?
Cash-out refinance loans aren’t necessarily free money, since you do have to pay closing costs (usually 3 to 6 percent of the mortgage). There’s also a cap on how much cash you can access—up to 80 to 90 percent of your equity.
Since it’s a new loan, it’ll have new terms and fees, and you might be paying it over a longer period of time than what was remaining on your original mortgage. And depending on what interest rates were like when you closed on your original loan, you could have a higher interest rate on the new loan. An additional risk, if you’re using the money to pay off credit card debt, is that you could end up running up a new balance.
How is a cash-out refinance different from a HELOC?
A cash-out refinance is a loan that replaces your old one in order to access up to 80 to 90 percent of your equity, while a HELOC, or Home Equity Line of Credit, is a second loan that’s based on the equity on your home. In a HELOC, you keep your current mortgage.
A HELOC also is structured like a revolving line of credit, where you borrow against the loan up to your limit. As you make payments, you free up the balance to use again. However, it’s not like a credit card in that you can borrow and pay balances on a monthly basis. Instead, a HELOC has a “draw” period (the period where you can access the balance) and a “repayment” period (where you repay). The length of these periods depends on you HELOC terms.
Another difference lies in the interest rate: A HELOC usually has a variable interest rate, unlike a cash-out refinance, where you lock in an interest rate.