Before my husband and I decided to sell our home and downsize, we thought about remodeling our current home. An updated kitchen would make it feel like a brand-new space without the headache of having to sell the property.
The only problem? We were a little short on the funds to shell out the thousands of dollars that a total kitchen remodel would have required.
Fortunately for us, we had been living in the home for a number of years and had some equity built up. A cash-out refinance was one consideration to help us come up with the cash to fund our dream kitchen.
Depending on your financial circumstances, the equity you have built up in your home, and your end goal, a cash-out refinance might be a good choice for you. Your financial goal can run the gamut from remodeling like we wanted to do, paying off some of your high-interest debt, or just storing away some money for a rainy day.
I’m here to give you a crash course in everything you need to know before you call the mortgage company.
What is a Cash-Out Refinance?
You might have heard of refinancing your home to achieve better interest rates or lower monthly payments, but what exactly is a cash-out refinance?
A cash-out refinance takes the place of your current mortgage and gives you a new, higher mortgage. The difference between what you owed on your previous mortgage and the new mortgage is given back to you in cash at closing.
The money is yours to spend however you choose.
You might long for home upgrades or you might need that money to pay down debt. No matter what your greatest financial need is, a cash-out refinance can help you achieve it.
There is one caveat. You usually can’t pull out all of your home’s equity. Equity is the difference between the amount you currently owe on your mortgage and the approximate value of your home.
For example, you may owe $200,000 on your current home but it appraises for $250,000. This means that you have $50,000 in equity.
In general, lenders want you to maintain some equity in your property. They typically only allow you to pull out 80 percent of your home’s value or less. The specific numbers will vary based on your lender’s policies.
Keep in mind that when doing a cash-out refinance, you don’t necessarily have to go through your original mortgage company. When we were thinking about our own cash-out refinance, we spent some time asking around and researching other lenders.
We were looking for a company that was reputable and responsive to us when we had questions. However, we were also looking for the best deal.
In the end, our original mortgage company wasn’t the one with the best refinance rates, so we decided to look elsewhere.
Essential Equity in Your Home
If you recently purchased your home or don’t have much equity built in the property, then a cash-out refinance probably isn’t for you. You will likely need at least 20 percent equity in the home if you want to take advantage of a cash-out refinance.
This can be a sizeable amount depending on the value of your home.
For a conventional mortgage, most lenders want you to have a loan-to-value ratio of 80 percent. This means that you are financing no more than 80 percent of what the home is worth.
To break it down further, this means that for every $100,000 that your home is worth, you are only borrowing $80,000.
While some lenders can and will issue conventional mortgages for 95 percent of the home’s value, this is not as common. When it comes to your cash-out refinance, lenders still want to see you maintain some equity in the property.
This is why you should have a minimum of 20 percent equity in the home.
There is one exception to this rule. If you qualify for a VA refinance, a lender can issue a new loan for up to 100 percent of the value of the property. If you have less equity built up in the home, you may not be able to withdraw as much cash.
Double-check your numbers and ensure that you have enough equity built up in the home to reach your goals, whatever they may be.
When we purchased our house, we put down ten percent. It was enough to qualify us for a conventional mortgage with our lender, but not enough for them to waive private mortgage insurance for us (more on this in a minute).
Over the course of five years, we had paid down another fifteen percent, leaving us plenty of wiggle room for our potential kitchen remodel.
Private Mortgage Insurance May Return
Make sure you pay attention to how much money you are borrowing. If you plan to borrow more than eighty percent of the property’s value, you will likely have to pay private mortgage insurance or PMI.
This payment is designed to offer security to the lender, but it does nothing for you if you miss a few payments.
PMI payments can range anywhere from 0.25 percent to two percent of your annual loan amount each year. Oftentimes, you can ask your lender to eliminate these payments once you have eighty percent equity built up in your property again.
Pay careful attention to your loan-to-value ratio when paying your bills each month so that you know when you hit this essential marker.
My husband and I were able to get the PMI on our home waived once we reached the 80 percent mark. All we had to do was write a letter to our lender asking for them to remove the PMI payment. It was as simple as that.
And sometimes, your lender may even cancel PMI automatically once a certain amount of equity has been reached. The terms of your PMI should be clearly laid out in your loan documents, but be sure to consult with your loan officer if you have any specific questions regarding your PMI.
You Need a New Appraisal
Chances are that the market has fluctuated since you originally purchased your home. Maybe you made some upgrades to it that boosted its market value. Whatever the case may be, a cash-out refinance is going to require you to have a new appraisal done on your home.
Appraisals are extremely important for your lender. They have to ensure that you are not attempting to borrow more money than your home is actually worth. Keep in mind that you will have to pay for this new appraisal which usually costs a few hundred dollars.
But, this cost may be worth it if it saves you money on your mortgage payments in the long-run.
Pay Attention to Your Credit
Refinancing your home can be a great way to lower your monthly payments or to receive better interest rates. Traditional refinancing is also a bit more lenient on your required credit score.
It typically only requires a minimum credit score of 580. However, things are a little different if you are interested in withdrawing cash during your refinance.
Because you are going to be increasing the value of your mortgage, your credit score typically needs to be higher. Most lenders ask for a minimum credit score of 620.
If you don’t know your credit score, there are a number of ways that you can gain access to the credit score that lenders are looking for. First, you can try to view your credit score for free through your credit card company, bank, or other financial institution.
Oftentimes, these companies will list your current credit score on account statements or elsewhere on your online account.
If your financial institution doesn’t offer free credit scores to you, you can always purchase them through reputable sites like myFICO.com.
The cost is relatively minimal and it can provide great insight into whether you are financially in a place to begin the process of a cash-out refinance.
When we were purchasing our first home, we had no idea how to gain access to our credit score. It was an elusive concept that lenders discussed with us when they told us that we didn’t have enough credit to qualify for a loan.
Over the years, we wanted to monitor it to see if we were making progress toward our goal of one day becoming homeowners. However, we found that gaining access to these scores was difficult.
If we had known some of these tools, it might have helped to push us along a little faster.
Low Debt-to-Income Ratio Required
How much money do you spend on your bills and financial obligations each month? If you are current with your budget, it should take you no time at all to tally up your expenses compared to your income.
Divide your expenses by your monthly income and multiply by 100 to determine your debt-to-income ratio.
For instance, if your total debts each month including your current mortgage total up to $1,000 and your income is $3,000, then your debt-to-income ratio is 33.3 percent.
When it comes to refinancing your home, most lenders want to see a debt-to-income ratio of less than 50 percent. This is because the more debt you have, the more at risk you are of potentially defaulting on your loan.
Financial institutions want to limit their risk, so make sure you take whatever steps needed to reduce your debt before you consider a cash-out refinance.
Verification of Income and Employment
Remember when you first applied for your mortgage? Well, you’re going to need to track all of those financial documents down again.
Gather up your most recent paystubs, W-2s, tax returns, and bank statements to submit to your lender. Just like you did when you initially purchased your home, you are going to need to prove that you have the capability of making payments.
In other words, they need to make sure you have gainful employment that can cover the cost of your monthly mortgage payment.
I know what a headache this can be. Because we just recently purchased a new home, the endless slog of gathering up financial documents is at the forefront of my mind. It can be tedious to sort through all of your old documents and submit everything to the lender.
But in the end, it is a great way to ensure that you aren’t borrowing more than you can afford to pay back. Your lender is going to look closely at your current income and tally up your debt-to-income ratio to ensure that you can afford a new, higher mortgage.
Pro tip: Stay as organized as you can throughout your initial mortgage process and try to keep all of your financial documents all in one convenient place.
A file cabinet or marked boxes works great for this without taking up too much space.
Closing Costs Count
Remember that there is more to pay for than just a new appraisal for your property. Whenever you close on a new loan, there are going to be closing costs to pay.
They can range anywhere from two to five percent of your new mortgage amount, adding up to thousands of dollars. Evaluate how much money you will be getting back and whether a cash-out refinance is really worth it once you factor in this added expense.
Refinancing only makes sense when you are able to cut your interest rate down by a percent or two. If your closing costs are going to outweigh the amount that you could save on your monthly payments, then a cash-out refinance may not really be worth it.
Closing costs can range anywhere from three to six percent of the loan value depending on the type of loan you will be using and your lender. While we ultimately decided not to refinance our current property, we did receive an estimate for the closing costs we should expect.
The total came to around $14,000 which made us really rethink the idea of refinancing the loan. The cost would eat up most of the money that we would be getting back.
Is a Cash-Out Refinance Worth it for You?
A cash-out refinance can offer you the means to pay down debt or make some much-needed home improvements. Your imagination could likely run wild with all of the useful ways that you could use those extra funds right now.
As long as you are investing the money wisely, a cash-out refinance could be a great idea for you.
Keep in mind that opting to refinance your home means you will have to go through the process of obtaining a new mortgage all over again. Your finances will be under scrutiny from your lender, and you may not walk away from closing with as much as you plan after closing costs.
Your monthly payments may even increase because you are borrowing more money and may have to pay private mortgage insurance as well.
And, this process can take a while, so you might want to consider the timing of your refinance as well. If you have a lot going on, or are on a specific personal timeline to have the refinance complete, don’t wait until the last minute to refinance your home.
Whether a cash-out refinance is right for you is a highly personal decision.
Weigh these seven rules to help you figure out if this step will help you financially.