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What Is A Cash-Out Refinance (Cash Refi) And How Does It Work?

Emma Tomsich5-Minute Read
November 23, 2020

If you’re thinking about making home improvements, consolidating your debt, or tending to other financial needs, you might be familiar with a cash-out refinance. A cash-out refinance takes advantage of the equity your home has built over time, and gives you a cash fund in exchange for taking on a larger mortgage.

In other words, a cash-out refinance takes your existing mortgage and replaces it with a new mortgage worth more than what you currently owe on your house. This difference between your existing mortgage and your new loan is paid to you in cash and can be used to meet your financial or home improvement needs.

In addition, it’s important to distinguish a cash-out refinance from a traditional refinance.

A cash-out refinance differs from a conventional refinance because it replaces your existing mortgage with a home loan worth more than what you currently owe, while a conventional refinance replaces your existing mortgage with a new one for the same balance.

In addition, a cash-out refinance is often used as an alternative to a home improvement loan.

If you’re seriously considering a cash-out refinance, we’ll explain its benefits and costs, while also comparing other options.

How Much Can I Cash-Out Refinance?

A cash-out refinance doesn’t add another monthly payment to your tab. Instead, it allows you to pay off your old mortgage and replace it with a new one.

For example, let’s say you bought a home for $250,000 and you’ve paid off $100,000. This means you still owe $150,000 on your home. Let’s say you want to use your cash-out refinance to pay off $25,000 worth of debt.

With a cash-out refinance, you take a portion of your home’s equity and add what you’ve taken out onto what you still owe on your original mortgage. For example, you would add the original $150,000 you still owe on your home plus the $25,000 you need to pay off debt, which means your new mortgage would be worth $175,000.

Your lender would then give you the $25,000 in cash 3 – 5 days after closing.

Benefits Of A Cash-Out Refinance

A cash-out refinance can be a smart way to take advantage of your home’s equity for many reasons. For example, it may be your most beneficial option if you’re looking to add value to your home or you’re hoping to qualify for lower interest rates.

A cash-out refinance can help add value to your home by allowing you to make home improvements and renovations. Whether you want to replace a broken system, update the interior or exterior, or even put on an addition, a cash-out refinance will give you the freedom to make these necessary changes. By using the equity your home has already earned to fund these improvements and renovations, your home’s value will significantly increase.

In addition, a cash-out refinance will be beneficial if you can qualify for a low interest rate. Compared to credit card interest rates, mortgage rates are generally lower. For example, if you were planning to replace your home’s HVAC system and you put it on a variable credit card, you might end up paying a high amount of interest plus additional fees for that unexpected bill. On the other hand, if you were to use a cash-out refinance to pay for the updated HVAC system, your interest rates will likely be lower. Typically, mortgage rates are lower than credit card interest rates, which can save you thousands in interest over time if you have enough equity to cover the bill.

Costs Of A Cash-Out Refinance

While a cash-out refinance might seem like your best option, let’s discuss the potential costs involved.

To begin, it’s important to remember that you will have to pay closing costs when you refinance. During a cash-out refinance, your closing costs may include credit report fees, appraisal fees, and attorney fees. Closing costs typically add up to about 2% – 5% of the mortgage. So if you’re only planning on taking out a small loan, determine whether or not the closing costs would negate anything you save with a lower interest rate.

Private mortgage insurance may be another unforeseen cost to a cash-out refinance. For example, if you borrow more than 80% of your home’s value, you’ll have to pay for private mortgage insurance. PMI typically costs from 0.55% – 2.25% of your loan amount each year. While this might not seem like a large expense right now, it can certainly add up over time.

Finally, it’s possible for a mortgage to have higher interest rates during a cash-out refinance. This is due to the fact that the homeowner agrees to new loan terms that may differ from the original loan terms. To be cautious, review your new mortgage’s interest rate and fees before agreeing to the new terms.

Cash-Out Refinancing Vs. A Home Equity Loan (HELOC)

When choosing between a cash-out refinance or a home equity loan, there are many factors to consider. Before going in depth, let’s first define what a home equity loan is.

A home equity loan or line of credit is a type of second mortgage, which allows you to borrow money as a lump sum of cash or as a line of credit. With a cash-out refinance, a home equity loan or line of credit can help pay for home renovations or free up debt. However, with home equity loans and lines of credit, the homeowner uses their house as collateral.

When you decide between a cash-out refinance or a home equity loan, think about how much money you need, how much equity you have, how much you are risking, and what your time frame for repayment is.

You can also choose what would be most advisable given your current circumstances.

For example, a cash-out refinance might be better if you plan to take out a large sum of money and use it all at once.

On the other hand, if you plan to take out a small sum of cash and spread it over time, a home equity loan or line of credit could be best for you. In addition, a home equity loan or line of credit could be the better option if your cash-out refinance mortgage terms are too high.

Regardless, a good rule to follow is the more cash you need, the more you should consider a cash-out refinance.

Is Cash-Out Refinance Taxable?

When getting a cash-out refinance, many homeowners wonder whether they need to report this money as income when they file their taxes.

The cash homeowners receive from a cash-out refinance isn’t free money, but rather a form of debt that must be paid with interest over time. With that being said, the IRS considers the money from a cash-out refinance as an additional loan, not as income. So homeowners don’t need to include this information when they file their taxes because it is not taxable.

However, in few instances, the interest from a cash-out refinance may be tax deductible. For example, if you use the money for a capital home improvement, you can deduct interest. This means in order to deduct interest, you must make some kind of home improvement that increases your property’s value. If you’re planning to get a cash-out refinance to pay off debt or take a vacation, you will be unable to deduct interest.

Learn More

When making financial decisions about a cash-out refinance, it’s best to consult with a mortgage expert to learn more. Mortgage experts at Rocket Mortgage® can talk to you about your financial goals and help you decide what option is right for you.

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    Emma Tomsich

    Emma Tomsich is a student at Marquette University studying Corporate Communications, Marketing and Public Relations. She has a passion for writing, and hopes to one day own her own business. In her free time, Emma likes to travel, shop, run and drink coffee.