Are you interested in cash-out refinancing? Cash-out refinancing can be a great way to free up some money for anything from paying for college or financing a home improvement project to building your savings. Before finalizing your decision, it’s important to understand precisely what cash-out refinancing is, the benefits of cash-out refinance, and what to be aware of when opting for refinancing.

What is Cash-Out Refinancing?

So, what exactly is cash-out refinancing? It’s the process of refinancing the mortgage on your home to use some of the equity you’ve earned over the years. For a cash-out refinance loan to work, the new mortgage loan needs to be larger than your original mortgage loan. That way, you can use the difference between the original and new mortgage loans.

How does a cash-out refinance work?

To refinance your mortgage, you are essentially replacing your old mortgage with a new mortgage. Part of a cash-out refinance is that you get to take out some money too. How much cash you can take out depends on how much equity you have in your home.

With a mortgage refinance, you may get a new home loan with a lower interest rate, a shorter loan term, or both. A cash-out refinance is somewhat different because you are taking some cash in a lump sum. In the end, you might have to settle for a higher interest rate than on your original mortgage as a result of the higher loan amount.

Lenders usually limit the cash you can withdraw to no more than 80 percent of your home’s appraised value. This is to make sure that there is a sufficient cushion after the refinance.

How to calculate cash-out refinancing?

Say you purchased a home five years ago for $150,000. Over the past five years, you have paid $50,000 off your loan. That means you now own $50,000 worth of your home and still owe $100,000. You can choose to refinance your mortgage for $150,000, meaning you would free up $50,000. By refinancing, you gain access to that cash now and continue to pay off your mortgage monthly. You have simply increased what you owe on your home over the years to acquire money now for your project or other financial needs.

3 Scenarios Where Home Refinance with Cash Out Makes Sense

1. Immediate access to cash

One of the main benefits of a cash-out refinance is that it can provide you with money that you can use immediately. This might help those looking to start a home remodel project or make an investment. You have worked hard to make payments on your mortgage over the years, increasing your home’s equity. Now you might be able to take advantage of that by refinancing your mortgage and gaining access to funds for other financial needs. Whether you’re seeking a small amount of money to purchase a used car or plan to use the money for more schooling, cash-out refinancing can be one option to acquire funding.

2. Ability to maintain or increase your home’s value

Why not use refinancing to increase your chances of ensuring your home’s value doesn’t decrease over the years? If you need some funding to start home improvement projects, cash-out refinancing could provide you with the money you need. Although this option extends your mortgage’s length, you could potentially increase your home’s value over time by making improvements. If you plan to sell your home at some point in the future, this option might pay off down the road. Make sure you’re prepared to handle any home improvement projects before refinancing your loan, though, so no money is wasted in the process.

3. Option to invest in your future

If you’re interested in a career change, want to head back to school, or need the funds to start your own business, it can be a time-consuming process trying to find the right loan. By opting for cash-out refinancing, you can gain access to the money you need by re-adjusting your mortgage. After doing some research, you may even find that cashback refinance is a more affordable option than turning to your credit card or searching for another type of loan.

Reasons to Use a Cash-Out Refinance

If you need a large sum of money and have enough home equity, cash-out refinancing might be a great option.

Here are some reasons people might want to use a cash-out refinance:

  • Lower interest rate – Most people refinance their mortgage because they want a lower interest rate.
  • Consolidate high-interest debt – People with a lot of credit card debt might opt for a cash-out refinance. They want to consolidate the high-interest debt, which is possible with a cash-out refinance. Keep in mind that you are also replacing a nonsecured credit card loan with a secured mortgage with a cash-out refinance. In other words, you could lose your home if you default on your mortgage.
  • Pay for a college education – You can use the funds from a cash-out refinance to either pay college tuition or pay off student loans. Generally, student loan debt rates are significantly higher than mortgage interest rates.
  • Increase the value of the home – If you need to make some major repairs or improvements, consider financing it with money from a cash-out refinance. Tapping your home equity might be a lot less expensive than other types of loans.

What to Keep in Mind with Cash-Out Refinancing

While there are plenty of benefits to cash-out refinancing and some scenarios where this is the right choice, it is important to keep in mind how this option could affect you.

What are the risks of using a cash-out refinance?

Cash-out refinancing may be a great option for some people, but not for everyone. Because refinancing is not without risks, you should do your homework and think about the risks before deciding.

Here are some reasons you might want to avoid a cash-out refinance:

  • You could lose your home – Remember that with a mortgage, your home is the collateral. And if you can’t make the payments, you could lose your home. When you take on additional debt or higher monthly payments, it heightens the risk of losing your home.
  • Higher interest rate –  Many people want to refinance their mortgage because they want to lower the interest rate. With a cash-out refinance, your new home loan’s interest rate may be higher than the current rate. If the cash-out refinance considerably increases your home loan’s interest rate, it may not be a smart decision.
  • The requirement to pay private mortgage insurance (PMI) – If you withdraw more than 80 percent of your home’s equity, you might have to pay PMI. On average, the PMI can add anywhere from 0.58 to 1.86 percent to your mortgage payments. According to Freddie Mac, you can expect to pay between $30 and $70 per month for every $100,000 you borrow. So, on a $500,000 home loan, you might have to pay an additional $150 to $350, a significant increase in the payment amount.
  • Potentially extend the life of your debt by decades – If you use a cash-out refinance to pay off high-interest credit card debt, you might drag out the repayment for several decades.
  • It might be tempting to use your home equity as a piggy bank – Tapping your home equity to pay for the wrong things is a bad idea. If you have poor spending habits, you could reduce your home equity and put yourself in a difficult financial situation. If you don’t have strong financial discipline, a cash-out refinance might be too risky.

When you choose to cash-out refinance, you agree to a new mortgage plan. For example, you may have made plans to pay off your original mortgage by a certain date. If you re-adjust your plan, you should consider whether or not you have job security, savings, and the discipline to handle extending your mortgage. Contact a mortgage expert and learn about your options for a cash-out refinance.