Cash-Out Refinance vs. Refinance
A cash-out refinance is similar to a normal refinance in that you’re changing the terms of your loan, but put simply, it means you’re taking out a new loan that’s larger than what you owe so that you can pocket the surplus cash. Your new mortgage balance (which you will have to pay back in full) now includes your previous mortgage balance, and the cash that you “cashed-out.”
Let’s say you bought a $215,000 home, and you’ve paid off $100,000. That means you still owe $115,000, but you own that $100,000 portion. That portion you own is called “equity.”
Now, in a normal refinance, you’d work with a lender to get a new loan for the $115,000 that you still owe. Preferably, you’d either find a loan with a lower interest rate than what you started with, and/or you’d make the length of the loan shorter so that it’s paid off quicker, allowing less time for interest to build up.
In a cash-out refinance, you get a new loan for the $115,000 you still owe, plus an extra amount (up to 80%-90% of your equity) that you want or need now.
Cash-out refinance: why do people get them?
Cash-out refinances allow you, the homeowner, to put that cash to work in a variety of ways. Many people spend their cash on:
- Home renovations (kitchen remodel, bathroom upgrade, new roof tiles, installation of A/C, etc…)
- Debt consolidation (using cash-out refinance cash to payoff high-interest rate credit-card debt)
- Education (college tuition payments)
- Personal Investments (Investing your cash into higher-yielding investments in liquid markets)
Here's a real world example:
Let’s say that house you bought for $215,000 is nice, but could really use a better kitchen. The one you have is outdated and a little dysfunctional. You’ve gotten some bids, and you know that your kitchen renovation will cost you $30,000. That’s not money that you just have lying around. How are you going to pay for your new kitchen?
This is where a cash-out refinance can come in handy. Remember how you’ve paid off $100,000 of your home loan, and you still owe $115,000? Well, since you need $30,000 for your new kitchen, you can go in and get a new loan for the amount you owe plus the amount you need for your new kitchen, totalling $145,000. Since only $115,000 of that goes toward what you owe on your home, the extra $30,000 goes into your pocket for your new kitchen.
Even with the recent changes to the tax code that took effect Jan 1, 2018, cash-out refinances are still a benefit from a tax perspective. Ultimately, the equity you've built up in your home is only realized as a profit (or loss) when you sell your home. With that in mind, any cash you receive from a cash-out refinance or HELOC isn't a taxable event — it's just money that's added to your overall mortgage debt. To be clear, you are still 100% responsible for paying this additional debt back, but in the context of the total set of options you have to obtain cash from your investments, tapping into your home equity via a cash-out refinance does not trigger a taxable event.
Risks to cash-out refinance: spending on frivolous expenses
A cash-out refinance isn’t right for everyone or every circumstance. Work closely with a professional you trust on any refinance, but take special care when thinking about a cash-out refinance. Traditional refinances are smart when done in the context of a macro environment shift where interest rates have lowered.
Cash-out refinances can be riskier, and you should never use them to pay for frivolous expenses like a big vacation or expensive new car. For one-time expenses like the ones just mentioned, those aren't investments with any potential for a return on investment (ROI); they just add to your total mortgage debt that you still have to pay off. If, by doing a cash-out refinance, you are increasing the likelihood that you'll be unable to pay, you could be needlessly putting your home at risk.
Conclusion – decide which option is best for you using these factors:
Deciding the best refinance option for you depends on many factors, and you consult not only one of our loan consultants, but also a tax expert. Here's a short-list of items you should have considered before making a decision:
- How much money are you thinking out of your home?
- How much equity do you have currently – what will your equity % be after the cash-out refinance?
- What will be the use of this cash – is there a return on investment?
- What's your time frame for repayment?
- Have you spoken with a tax expert or an accountant about your plans?
- What are current interest rates?
Reach out if you're actively considering a refinance; we can run different loan scenarios for you and help you find the best loan for your financial profile. Call us at 833-600-0490 or email us at [email protected] for more information.