Last editedMay 20213 min read
Refinancing allows you to negotiate new terms for a loan. This might lead to lower interest rates, a different repayment schedule, or a reduction in monthly payments. In the case of a cash out refinance, you can also access home equity. So, how does a cash out refinance work? We’ll explain in this guide.
What is a cash out refinance?
Cash out refinancing applies primarily in real estate. The refinancing process entails replacing your old mortgage terms with a new contract. It’s one of the best ways to reduce a larger monthly expense or take advantage of a drop in interest rates.
In the case of cash out refinancing, you can reap all the usual benefits of refinancing a loan including lower rates and extended payment contracts. With a new loan contract, you’ll borrow a larger amount than what was previously owed. This is taken out in cash that can be used to fund large purchases, pay down debts, or even use for investing purposes.
How does a cash out refinance work?
Now that we know a little more about cash out refinance, it’s helpful to take a closer look at how this works in practice.
To get started, you’ll need to find a lender and fill in your application. The lender assesses your application, factoring in your credit profile, remaining balance, and previous loan terms. After appraising the home value and performing an underwriting analysis, the lender then makes a custom offer.
If you accept the new terms, your new loan pays off the previous loan and locks you into a new contract. Normally, refinancing alone doesn’t result in a cash payment. However, a cash out refinance increases the loan to value percentage. Your old loan isn’t just paid off, it’s extended so that you can receive up to 125% of the property value. This extra percentage is given as a lump sum, serving as a personal loan.
As with any new loan, the terms will come with an instalment payment schedule as well as either fixed or adjustable interest rates. Be sure that you understand all of the cash out refinance rules before accepting.
Cash out refinance pros and cons
Is cash out refinancing a good idea for you? This will depend on your financial goals and level of risk tolerance. Here are a few reasons to consider getting a cash out refinance:
1. Lower interest rates
The goal of most refinancing is to save money, including taking advantage of lower interest rates. These usually lead to lower monthly payments, leaving you with more money in your pocket on top of the extra cash.
2. Pay off debt
If you’re paying off higher interest loans or credit card balances, it might make sense to refinance in order to pay down the debt.
3. Pay for business opportunities
Cash out refinance rates can be more favorable than other types of loans, making this an option when you need to pay for a new business project. There are no cash out refinance rules stating how you must spend the cash.
4. Pay for home repairs or extensions
You can use home equity to access cash for improvements, upgrades, and repairs. This adds value to your property, meaning the refinance has paid for itself.
On the other hand, there are also potential disadvantages to cash out refinancing.
1. High closing costs
Cash out refinance rates will vary widely depending on your financial circumstances and the lender’s terms. Be sure to look carefully at all closing costs, because these can be quite high – up to 5% of the total loan.
2. Risk of foreclosure
Borrowing more money always comes with added risk. When you are borrowing more than your property is worth, you’re taking a gamble. Although the loan repayments might be lower each month, this is a long-term loan. Be sure you can repay it over time. If you default on payments, you run the risk of foreclosure.
Is cash out refinance worth it?
As you can see, there are both advantages and disadvantages with cash out refinancing. One way to make a decision is by considering the loan’s break-even point, or time it takes for your savings to equal the new loan costs. For example, imagine that it costs $10,000 to secure your new loan, including all fees. As a result, you save $500 per month on your monthly payments. You can divide $10,000 by $500 to determine the break-even point. In this case, it would take you 20 months to break even.
Finally, some business owners decide to rely on cash out refinance to fund new investments. This is a tempting use of your lump sum, but make sure you’re going to be able to repay your loan if the market takes a tumble. Make sure you’re working with a trusted financial advisor before signing any new loan agreement.
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