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What is a Cash-Out Refinance and How Does It Work?

By Brian Kline | November 22, 2022

Buying a home is a huge accomplishment but in today’s market, you don’t always get the home that you dreamed of. You may need to make some changes and upgrades after achieving the initial purchase. Two or four years down the road might be when you look into a cash-out refinance.

After saving for years for the down payment, it can be difficult to keep saving to make improvements to the house you were finally able to buy. After scrimping and saving for years, you probably need some new clothes, a vacation, or a newer car. While finally becoming a homeowner is admirable, there are other things that you need in life. A cash-out refinance can be used for anything that you want but home improvements are one of the top reasons. After you build some equity in your home, refinancing to make home improvements can be a good strategy to both improve the quality of your home life and increase the value of your home.

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What is a Cash-Out Refinance?

An advantage of being a homeowner is that paying down your mortgage each month also grows your equity every month. Along with the appreciating value, you are building wealth every time you make a mortgage payment. You can convert that equity into cash and continue paying off your mortgage to continue building wealth as long as you are a homeowner.

A cash-out refinance is not another loan. When you refinance, you pay off the original loan and take out a new loan against your house. The cash that you walk away with is part of the equity that you have already earned by owning a home. You won’t have another loan payment to make but your mortgage payment will very likely be higher because you will be borrowing more against your home and interest rates are higher today than they probably were when you took out the original mortgage a few years ago. In other words, with a cash-out refinance, you borrow more than you owe on your current mortgage and pocket the difference.

A cash-out refinance is not a second mortgage. You might have different terms and conditions that apply to your new mortgage, but you won’t be dealing with two different lenders and have two different sets f rules to keep track of. Your first mortgage will be paid off in full and a new mortgage takes its place.

How Does a Cash-Out Refinance Work?

There will be a cost involved to take out a new mortgage. It’s mostly the same as when you took out your original mortgage. Except, you don’t have to come up with that big nut of a down payment because the equity in your home qualifies as the down payment. Not only do you want to look for the best terms on your new loan, but you may also want to make major changes such as taking out a 20-year mortgage instead of a 30-year mortgage. Some people look for a better interest rate but it’s a tough market for interest rates at this time. One thing that you can look at is leaving at least 20% of your equity in the house so that you don’t have to pay Private Mortgage Insurance (PMI) on your new loan. So, let’s consider what a cash-out refinance might look like…

Let’s say that you bought a home for $200,000 four years ago and you’ve paid off $60,000. This means you still owe $140,000 on your home. However, the value of your home is much higher than your outstanding balance. Today, the value of your home could easily be $280,000. That means you have $140,000 in equity ($280,000 - $140,000). If you leave 20% of your equity in place so that you don’t have to pay PMI, you could cash-out up to $224,000.

If your credit score and debt-to-income ratio are in good shape, you could probably qualify for that full $224,000. However, what you want to do is a major $60,000 remodel. So, you decide to cash-out $60,000 and leave the remaining $164,000 so that it continues growing your wealth. Your new mortgage would be for $220,000 and you would have $60,000 in cash to spend any way that you want. Something that you do need to figure into the calculation is the cost to take out a new loan. While you won’t need to come up with a down payment, there will be other traditional closing costs. Your home will need a new professional appraisal, and there will be application fees, title insurance fees, etc. Chances are good that you can roll those costs into your new mortgage instead of paying them out of your pocket.

When you refinance, you can do anything you want with the money. You can make improvements on your property, catch up on your student loan payments, cover an unexpected medical bill, buy a new car, or take a dream vacation. 

What else do you think borrowers should be aware of before going with cash-out refinancing? Please leave your comment.

Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years with articles listed on Yahoo Finance, Benzinga, and uRBN. Brian is a regular contributor at Realty Biz News
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