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A homeowner’s guide to cash-out refinance

A homeowner’s guide to cash-out refinance

For most people, home is a place they live in. A place where they make memories with their family, their kids, their loved ones. Memories that they can cherish some day and relive those moments.

In addition to that though, what makes a home even more special is it’s form as an asset. Something that is of value. Something that one can sell some day and realize that value.

Other things such as gold, stocks, bonds, even one’s car, and other precious possessions are classified as assets too. Because they all have that same characteristic that a home does – sell the asset and receive cash in return. 

Exploring cash-out refinance merits is timely for one other reason. We are currently at a historic level of homeowner’s equity in real estate:

By tapping into this equity, US homeowners can help finance key life events, including child’s education, renovation or even use cash-out proceeds towards down payment for purchasing an investment property.

Can one realize that value without having to sell the asset?

Absolutely. One can borrow money against a lot of assets one owns. One’s property, the gold one owns, or stocks and bonds.

But there is something unique about a real estate property that most other assets don’t offer.

Real estate is unique

With gold or jewelry, the owners can get cash but they will likely have to leave the asset with the lender as collateral. They cannot use it or keep it with them.

Owners of stocks and bonds can borrow money as well. But that money cannot leave the brokerage that holds those assets for them. They have to invest the cash in other assets at the same place. In other words, invest in stocks, bonds and other exchange-traded assets only.

When it comes to real estate though, they can not only keep the asset with them but they can also continue to use it like they normally do. And yet, they can borrow cash that can be used for any purpose. The best of all worlds as one would say.

And that’s not all. The interest rates at which they can borrow money are very reasonable too. The transaction through which they can do so is what is called as a cash-out refinance.

What is a cash-out refinance?

A cash-out refinance essentially is what the name suggests. Get cash as a part of a refinance of an existing mortgage.

Immediate next question: Is that possible? How do I get the cash? How much cash can I get?

For starters, yes, you certainly can. If you didn’t know that, there’s nothing to feel bad about. A lot of people don’t.

As far as the questions about why, how and how much go, that’s what we are about to discuss in great detail.

Why do a cash-out refinance?

People do a cash-out refinance when they want to borrow cash for a need they have. More specifically though, people use it when they need to borrow large sums of money at a reasonable cost. 

Since the closing costs, the time taken and the work involved with a cash-out refinance is significant, it doesn’t make sense when the amount is small or the need is urgent. 

A few examples of situations where a cash-out refinance makes sense are:

Debt consolidation

If you have several credit lines open with high balances on them and at high rates of interest, it makes sense to pay them off using cash from a cash-out refinance. 

Reducing the number of credit lines can not only help lower your total monthly debt payment, it can help improve your credit score.

Home renovation and improvement

Home renovations can often be quite expensive. Using equity in one’s home as a source of cash to renovate a home is a good way to finance it at a very reasonable rate.

One can think of it as making an investment in the home itself. By doing so, not only do you get to enjoy the newly-modeled home, the value of the property is also likely to go up which ultimately benefits you when you sell the property.

One note of caution though: not all improvements and home renovation lead to an appreciation in home value. Some improvements can, in fact, cause a reduction in value. So it’s worth consulting renovation professionals to review if your planned renovation will yield an increase in value. 

Investment

One popular use of a cash-out refinance is when there is a new investment opportunity. For example, buying another property or investing in one’s business.

If the Return-On-Investment (or, ROI) on the investment is higher than the rate of cash-out refinance (after taking into account the closing costs), then it might not be a bad idea to borrow at a low rate and invest it at a higher rate to make extra income.

College education for kids

One common use of cash-out refinance is to borrow money to finance the education for kids. The main reason is that the interest rate on education loans can be quite high.

If you have sufficient equity in the home and interest rate for the refinance is significantly lower than that of an education loan, it might make a lot of financial sense.

How does a cash-out refinance work?

When one refinances a mortgage, they often refinance because interest rates have gone down since they got their existing mortgage and they want to take advantage of the lower rates and thereby, lower their monthly payment.

Getting cash is another reason why people refinance. In such scenarios, rates may not have gone down compared to the rate they have. But the incentive to refinance is the cash it’ll fetch them that they can use for many different purposes, as highlighted above.

As an example, say someone owns 50% equity in their home with the other 50% owned by the bank or lender that issued the mortgage that exists on the property. And suddenly, a need for cash arises.

There are multiple options to obtain that cash:

Personal loan

Rates for a personal loan are much higher because there is no collateral involved. As a result, the risk for the lender is high. And the higher the risk, the higher the interest rate they charge due to compensate them for the risk involved.

Home Equity Line Of Credit (HELOC) 

While the rate for a HELOC is lower than that of a personal loan, the rate is still higher than the rate of refinancing an existing mortgage on a property.

The reason for this is that while the HELOC is backed by property as the collateral, the HELOC issuer does not have the primary lien position on the property. 

In case of a default, the primary mortgage issuer has the first claims on the proceeds from the sale of the property. The HELOC issuer only gets paid if there is money left after paying off the primary lien issuer. 

As a result of this, the risk for the HELOC issuer is higher than the primary mortgage. Therefore, the rate on a HELOC is higher.

Cash-out refinance

A cash-out refinance is a great option for those who want to take cash out and not pay as a high rate of interest. Hence the reason for its popularity.

However, there are limits on how much cash you can get and the closing costs are often high enough for it to not make economic sense. But for a lot of people, the benefit of a lower rate is high enough to pay those costs and put in the effort. 

HELOC vs. Cash-out refinance – Which one is better?

People who need cash often contemplate whether to go with a HELOC or a cash-out refinance. Even though we mentioned above that a cash-out refinance offers a lower rate, it may not be suitable for every individual.

Because closing costs with a cash-out refi are higher and the effort required is a bit more, HELOC can be better when your need for cash is short term.

The reason is that with a HELOC, the process is relatively faster and the closing costs are lower. If your need is only for a year or two, taking a higher rate for a short period ends up being cheaper overall because the closing costs can be quite a bit lower with a HELOC.

If the need for cash is more medium to long term and the amount of cash required is significant, a cash-out refinance may end up being a better deal because you’ll likely be paying interest for many years. In such a case, it’s worth paying the higher closing costs. The table below compares the HELOC vs. a cash-out refinance.

Comparison between a HELOC, Second Lien Mortgage and a Cash-out refinance

HELOC vs. Second Lien Mortgage vs. Cash-out Refinance

  Cash-out refinance Home Equity Loan Home Equity Line of Credit (HELOC)
Interest  Rate Lower Higher Higher
Qualification  Criteria Like a regular mortgage Easier Easier
Closing  costs Like a regular mortgage Like a regular  mortgage Lower
Cash-out  Limit Read section “How much cash  can I get?” below Lender specific, can be $0.5M Upto 90% CLTV *
Worth  putting in the effort when…. Need for cash is for medium to long term Fixed monthly payment is preferred Need for cash is short term (i.e. 1-2 years) or credit line for 10  years
Processing  time Could be a month or more Could be a month A few days
Appraisal Required in a lot of cases Fly by appraisal May be waived by  the lender

* CLTV = Combined-Loan-To-Value (Ratio between “All loans on the property combined” and the “Property Value”)

Other than a higher rate, there are two other issues with a HELOC:

Firstly, when you have a HELOC on a property, the process to refinance the first mortgage becomes a bit more involved. 

In such a situation, when you refinance the primary mortgage, you have to request the HELOC issuer to let the new mortgage take the primary lien position. This request is called a “subordination request”.

While most HELOC issuers allow that, the process can take some time and it’ll likely also cost money in the form of a “subordination fee”.

The other problem with a HELOC is as follows: Let’s say you have a HELOC on a property and now want to consolidate both the primary and the secondary mortgages into a new mortgage to get a net lower rate. 

When you do that, unless both the mortgages were taken out at the same exact time, the transaction will classify as a cash-out refinance even if you don’t take any cash out. And a cash-out refinance tends to have a higher rate than a rate and term refinance (i.e. no cash).

Qualifying for a Cash-out refinance

The process of qualifying for a cash-out refinance is the same as that of getting a regular mortgage:

Stable source of income – One has to demonstrate a stable source of income to qualify for a cash-out refinance.

Maximum Debt-To-Income (DTI) ratio – The total monthly debt payments can be a maximum of 50% of monthly income. In many cases, that limit is even lower at 43% or below.

Credit score requirements – A minimum credit score is required. Having a score higher than that helps one qualify. But the rate is dependent on how high the score is. The higher the score, the lower a rate one can get for the cash-out loan.

Cash-out limit – One cannot borrow more than a certain percentage of the value of the property. The combined Loan-To-Value ratio can be a maximum of 80%. In many cases, that limit is even lower. See the next section: “How much cash can I get?” for more details on that.

How much cash can I get?

A cash-out refinance gets a borrower a lower rate only because the lender has a lien on the property and the property is held as collateral.

For that reason, a lender will never lend the borrower an amount that is more than the value of the property. In fact, for conventional loans, the limit is significantly below the value of the property.

And what is that limit? Well, borrowers can have multiple loans against their home. When doing a cash-out refinance, the maximum cash a borrower can get is calculated such that the total of all such loans is no more than 80% of the value of their home. In other words, the Combined-Loan-To-Value (CLTV) of their home is less than 80%.

This limit for second homes and investment properties is only 75%. And for 2-4 unit multi-family properties, that limit is even lower at 70%. See the table below that shows limits for conventional loans.

Conventional Loans Combined Loan-to-Value (CLTV) Limits

Property Type Maximum LTV, CLTV, HCLTV
Primary Home 1-unit 80%
2-4 units 75%
Second Home 1-unit 75%
2-4 units Not allowed
Investment Property 1-unit 75%
2-4 units 70%

See Fannie Mae Eligibility Matrix for more detailed information.

Still not sure if a cash-out refinance is right for you?

The objective of this article was to share everything one should know before deciding on a cash-out refinance. Things such as why one should consider this option, when it would be a good idea, how much cash can one borrow, along with a lot of other information.

It’s quite possible that even with all the information we provided above, you are still not sure about your decision and/or are not sure if a cash-out refinance is good for your situation.

If that’s the case, please feel free to reach out to us. At Stem Lending, our job is to guide you and help you make the most informed decision. If you are already sure about it though, you can start right away at: stemlending.com/apply

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