Cash-out Refinance Explained

coins spilling out of a glass jar

What is Cash-out Refinance?

When you swap your existing mortgage for a new, larger mortgage, borrowing against your home equity, it is called a cash-out refinance. You can borrow more than you currently owe. The funds are released to you directly, and you can use them to fulfill any of your financial needs – from paying a high-rate debt to purchasing a new car. However, to use cash-out refinance as a way to refinance a home loan, you must have equity built up on your home.

How does Cash-out Refinance Work?

Cash-out refinance is a great option for borrowing against your home. You will be able to access your home equity via a first mortgage in cash-out refinance in contrast to via a second mortgage as in a home equity loan or HELOC. While conventional refinancing substitutes your existing loan with a new one for the same balance, cash-out refinance lets you do the same but for a higher loan amount i.e. you get disbursed part of the difference between the mortgage amount and the home’s value. Consequently, the interest rate is slightly higher due to the higher loan amount. That said, you cannot cash out 100% of your home equity. Your lender determines the amount of equity you can access and can sometimes be lower than you expect. Most lenders require that you leave at least 20% of your home equity after refinancing. This is used as protection by the lender on the occasion that you default on your loan repayment.

Here’s an example. Let’s say you bought your home for $200,000 and have $100,000 left on the home loan. You can borrow $60,000 of your equity when lenders allow you to borrow 80% of the value of the property, taking into account the debt you have left to pay.

Pros of Cash-out Refinance

1. Lower interest rates

When you refinance a home loan using cash-out refinance, you’ll be able to borrow at a lower interest rate than a home equity loan or home equity line of credit (HELOC). A cash-out refinance is the first mortgage which means that they are paid first in the event of foreclosure, bankruptcy, or judgment, which is why they have lower interest rates.

2. Debt consolidation

You can save a lot of money by using the money from cash-out refinance to pay off high-interest debts such as credit card debts.

3. Tax deductions

If you use the funds from a cash-out refinance for buying, building, or upgrading your home significantly, then you may qualify for a mortgage interest deduction on your cash-out refinance. There are a few other guidelines you must follow, but the interest you pay on your mortgage can help you reduce your taxes.

4. Flexibility

Once the funds hit your bank account, banks do not have control over you spend the money received from a cash-out refinance. You can use the cash however you want.

5. Profitability

If you put the money from cash-out refinance towards repairs and renovations, then it could increase the value of your home.

Cons of Cash-out Refinance

1. Extended duration

Since you take a new mortgage in cash-out refinance, it may take longer for you to pay it off.

2. Foreclosure risk

When you are borrowing against your home, your home serves as the collateral. And if you fail to make the payments, you run the risk of losing your home.

3. New terms

Your new mortgage will have different terms than your previous mortgage. Therefore, it is important that you check and understand all the terms before you agree. Also, you might end up paying more mortgage interest over time because of the longer loan term.

4. Closing costs

When finalizing a mortgage, you’ll have to pay myriad fees for the services and expenses, which are known as closing costs. As with any refinancing, you’ll pay closing costs for a cash-out refinance. Closing costs range from 2% to 5% of the mortgage, which can total thousands of dollars depending on the size of your loan amount.

5. Private mortgage insurance (PMI)

You have to pay private mortgage insurance (PMI) if you borrow over 80% of your home’s value or don’t have at least 20% equity after cash-out refinance. It serves as a protection for the lender if you fail to make the repayments and typically costs from 0.55% to 2.25% of your loan amount annually. The cost-effectiveness of a cash-out refinance is lost if you have to pay private mortgage insurance.

When to Use Cash-out Refinance

If the value of your home has increased or you have built equity over time with on-the-dot payments, then it might be a good idea to use cash-out refinance. Cash-out refinancing is an easy way of borrowing against your home and cover huge expenses while paying low interest.

Cash-out refinance may not be suitable for you if you cannot afford the closing costs. Closing costs and other fees are pretty high for a cash-out refinance in comparison to other home equity loans.

Nevertheless, cash-out refinance is not the only way of borrowing against your home equity. There are home equity loans and home equity line of credit.

Bottomline

Your home equity is an asset. Cash-out refinance can be an affordable way of borrowing against your home and leveraging the equity you have built. However, be mindful of the interest you’ll pay in the long run and the effect it will have on your big-picture financial goals. Compare the pros and cons of cash-out refinance and use it to get yourself on a sounder financial footing rather than spending it on frivolous ventures with no return on investment.

Cash-out refinancing must be handled cautiously and may not be a good idea in some circumstances. Please contact our experienced Nepalese mortgage brokers now, if you are considering a cash-out refinance.

Author:

Kiran Thapa

Seema Lama

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