You have equity in your home and you want to use it. You have several ways to get access to it including a cash-out refinance. If you choose the cash-out refinance, you refinance your first mortgage for a larger amount than what you owe on it now. This can be the right idea for some people, but not everyone. Keep reading to figure out if a cash-out refinance is right for you.
Understanding the Cash-Out Refinance
First, let’s make sure that you are clear on the cash-out refinance. It’s not a second mortgage. It’s a first mortgage that pays off your existing first mortgage and gives you the proceeds in cash. You can then do what you want with the funds.
Typically, you can borrow up to 85% of your home’s value in a cash-out refinance. Your lender will first pay off your existing mortgage and keep any money for the closing costs, if you wrapped them into the loan. The remaining funds will come to you, usually as a check. You can deposit the funds wherever you see fit and use the funds as you wish.
You start making payments on the cash-out refinance like you did when you bought the home. If you closed on your loan on May 15th, you would owe your first principal and interest payment on July 1st. You then make payments for the next 15 – 30 years, depending on the chosen term.
Figure Out Why You Need the Funds
Now, if you are thinking of cashing into your home’s equity, you should figure out why you need the funds. The reason will help you decide if it’s a good choice, as not all choices are created equal.
For example, some good ways to use home equity include:
- Renovate your home (make necessary repairs)
- Pay for college (if you’ve exhausted all federal loan options)
- Pay off debt (if you can keep yourself from charging the debt up again)
These reasons will put your home equity to good use. Remember, you’ll pay principal and interest payments on the loan pretty much right away, so you want to make sure that the use of the funds is worth the higher payments you now have.
A few other reasons you may want to consider using your home equity, but you should exercise caution include:
- Paying for a wedding
- Paying for a vacation
- Using funds for retirement
- Using funds as an emergency account
These reasons can be useful as well, but they are mostly unnecessary expenses. For example, you don’t have to have a huge wedding. Even if it’s for your child, you can keep the wedding within your budget and leave your home’s equity alone. The same is true for a vacation or even retirement funds. You should tailor your lifestyle to fit your budget, rather than living outside of your own means. Of course, the emergency fund can be necessary should you not have funds set aside for a disaster.
If you’ve decided that you need the funds and it’s worth the interest you’ll pay, go ahead and use the cash-out refinance.
What Other Options do You Have?
Now that you’ve figured out why you need the funds, you should compare your cash-out refinance option to your other available options.
One of the top competitors is the home equity line of credit. This is a second lien on your property. You don’t touch your first mortgage when you take out a HELOC. Instead, you borrow your equity separately. When you close on the loan, your lender will put the funds in a checking account for you to access them. If you don’t need the funds, you can leave them in that account and you won’t owe a dime of principal or interest. As soon as you withdraw funds, though, you’ll make interest-only payments on the amount for the first 10 years. After that, you’ll owe principal and interest payments for the next 20 years or until you pay the loan in full.
You may also use the standard home equity loan. This is also a second lien on your property, but it’s a loan, not a line of credit. Like the cash-out refinance, you’ll receive the full amount of the equity that you borrowed in hand. It doesn’t go into an account and you start making principal and interest payments right after closing on the loan.
Which Option Suits you the Most?
Now that you know your options, it’s time to decide which one is right for you. Ask yourself the following questions:
- Do you have a great interest rate on your first mortgage? If you do and rates aren’t nearly what you have now, leave the first mortgage alone. You can opt for the home equity loan or HELOC instead, leaving the main portion of your housing debt alone.
- Do you need continual access to the funds? If you have an ongoing project or an ongoing need for funds, the HELOC may be the better option. It’s like a credit line that you can keep drawing on as you repay the funds. This can get you further than a one-time lump sum payment with the cash-out refinance.
- Can you get a great interest rate? Cash-out refinances are riskier for lenders, which means they often have tighter restrictions and charge higher interest rates. If you don’t have great credit and/or a low debt ratio, you may not be able to secure the lowest rate and may want to explore your options for a HELOC.
Is a cash-out refinance right for you? There isn’t a blanket answer to this question. You have to assess your situation to see how it compares to the available options. This way you can make the choice that is right for you.