7 Reasons to Consider a Cash-Out Refinance
If you’ve got substantial equity in your home and need cash for home improvements, debt consolidation or unexpected expenses, a cash-out refinance may be the way to pay for it.
A cash-out refinance replaces your existing mortgage with one for more than you owe on your home. They are typically limited to 80% of your home’s equity. Here’s how it works:
Let’s say your home is worth $350,000 and you still owe $100,000 on your current mortgage. This means you have $250,000 in home equity. Suppose you need $50,000 for a room addition? You can refinance your new loan for $150,000 — $100,000 to pay your original mortgage balance plus the $50,000 you need for the room addition.
You can use the funds from a cash-out refinance for any reason but here are some of the most common purposes and potential benefits you may get from refinancing:
One of the most popular ways people use cash-out refinancing is to make home improvements. If you’re like most folks who have been homeschooling your kids or working from home during the pandemic, it’s likely you’ve had plenty of time to take a good look around and notice things needing repair or improvement.
Whether you use the cash to replace a roof, renovate or add another room, chances are you may see a good return on your money by boosting your home’s value in the long run.
Mortgage and refinance rates are currently at historic lows. Depending on your credit score and other factors, you may be able to take advantage of mortgage interest rates well below the wallet-busting 16.63% rate seen in 1981, for example.
With the APR for all types of credit cards currently averaging between 15.57% and 22.87%, now may be the time to bank lots of money by using a cash-out refinance loan to pay down high-interest-rate debt.
Let’s face it. Life is unpredictable. Unexpected expenses, such as educational and medical ones can take a big bite out of your budget, especially if you do not have an emergency savings fund to pay for them. An alternate source of money from a cash-out refinance can help alleviate some of the uncertainty of figuring out how to deal with life’s all-too-common surprises.
For example, consider that the average college budget for an in-state student attending a four-year public college in 2020-2021 averages $26,820. Student loans and grants don’t always cover extras, such as transportation or the full cost of a semester abroad. Your options are either to forgo these nice-to-haves of campus life or have access to another source of funding.
Likewise, even with medical insurance, a brief hospital stay could result in a mountain of unreimbursed medical expenses in the form of coinsurance and deductibles. A cash-out refinance could be a relatively low-cost to pay for that if you’re qualified and have the equity in your home.
Cash for other Investments
Some borrowers use a cash-out refinance to purchase a rental or other investment property. In markets showing robust increases in home values, it may make sense to use the cash to buy a vacation home or other property to expand your real estate portfolio.
In some cases, you may see gains on your investment that outperform similar investments, such as mutual funds, money market or government bonds. Likewise, depending on the type of loan you take out for your investment property, you could potentially move in with a small down payment depending on your credit and other factors, such as the type of mortgage loan you qualify for.
Boost Your Credit Score
If you’re like most of us, chances are you have one or more credit cards. Americans carry an average of $6,194 in credit card debt, according to a 2019 report by Experian. That can be costly particularly if you have high-interest credit cards and carry a balance from month to month.
Paying off one or more of your credit cards can actually help boost your credit score by reducing your credit utilization ratio. That’s the amount of credit you’re currently using compared to the total amount available to you — one of the main factors affecting your credit score.
Low Interest Rates
Cash-out refinance rates are currently at historical lows and may present an attractive alternative to personal loans or a home equity line of credit (HELOC) for renovations or other purposes, especially if you bought your home when average mortgage rates were high.
What rates you are offered will generally depend on your credit worthiness, how much equity you’ve built up and what your loan-to-value (LTV) is, which most lenders cap at 80%.
The money you get from a cash-out refinance isn’t considered income; it’s considered a loan. Therefore, you don’t have to pay taxes on the cash. Instead, you may be able to take a tax deduction if you bought points to lower your interest rate on the loan.
In addition, there are several home improvement projects that may qualify for a deduction, such as PMI, also known as private mortgage insurance. The key is they must generally be defined as capital improvement projects that increase the value of your home.
Generally, things like fixing windows or painting a room do not qualify for a tax deduction. However, adding a swimming pool, replacing a roof or putting up a permanent fence around your property may qualify for tax benefits. Before claiming a tax deduction on money you spend from a cash-out refinance for home improvements, it may be a good idea to consult with a qualified financial advisor.
The Bottom Line
Rising home prices and historically low mortgage rates put homeowners in the driver’s seat when it comes to cashing out on their equity. However, not everyone will qualify for a cash-out refinance. Your credit score and debt-to-income ratio will come under the spotlight and you will likely have to pay closing costs just as you did when you took out your initial mortgage.
Still, a cash-out refinance may make sense if you have adequate equity in your home and qualify for the best interest rates. And kudos to you if your home improvement project qualifies for a deduction when tax time rolls around.
For more information about cash-out refinancing, click here.
SVP, Divisional Production Executive
Hamilton Home Mortgage