What is a cash-out mortgage refinance, and how do you know if it is convenient for you?
Let’s review these four steps: Understanding the process, home equity as a percentage of your home value, the qualifications for having the cash-out mortgage refinance, and doing your math.
- Cash-out mortgage refinance
A cash-out refinance will replace your current mortgage with a new higher amount mortgage, giving you cash back after paying off the existing mortgage, other liens, and the costs associated with the new loan.
The new mortgage will have different terms from your current one; after all, it is a new mortgage. It can be a different number of years, and the interest rate will be determined based on the current market, which means that the interest rate can be higher or lower than your existing mortgage. You can get this service from your current lender or other lenders.
To know if this is a good move from your end, we will first review how much equity you have in your home and how much cash back you estimate getting from the lender. You need to consider the bigger financial picture. Can you lower your current interest rate? Can you consolidate debt, and with the cash-out, is it a priority or urgent enough to financially justify this transaction? There are many options to consider.
- Home Equity
Home equity is the cash value you have in your home. It is calculated by reducing the debts attached to the property (mortgage, Home Equity Line of Credit, and other liens) from the property’s current market value. By calculating your home equity, you will come up with a cash amount and a percentage of the total debt related to the home’s value. The Loan-to-Value (LTV) percentage will allow you to estimate your options.
For example, if you bought a house a few years ago for $230,000. Today, you think your home is valued at $280,000. You have a mortgage with a balance of $140,000 and another Home Equity Line of Credit with a balance of $10,000.
An appraiser will determine the actual value of the home. Let’s assume it is $280,000
The total liens on the home are $150,000. You have $130,000 of equity, and your LTV is 53%.
Most mortgages will allow you to borrow up to 80% of the home value for cash-out purposes. (VA loans have other limits). Continuing with the previous scenario, 80% of your home value is $224,000, so this will be the maximum amount of the new loan. What if you began the process, and the appraisal returned with a higher or lower home value? You calculate the 80% of the home appraised value, to receive the new maximum loan amount. If you decide to borrow a higher amount, the lender will check if you qualify. If due to the appraised value, you can borrow a lower amount than initially anticipated, rethink if this transaction aligns with your financial goals.
- Qualifications
The qualifications for a cash-out refinance are similar to a rate and term refinance, which means refinancing the existing loan with no cash back. The difference will be the loan amount, as you are refinancing a larger amount to allow the cash back. The lender will require a qualified income, calculating the length of employment; the income documentation will vary based on the type of income (employed, self-employed, or passive income). A lender will check your credit score. Most programs will require a minimum of 620 credit score, and based on your credit score, some lenders will limit the maximum loan amount to less than 80% LTV.
The lender will calculate your Debt-to-Income (DTI) percentage, dividing all your minimum monthly payment debt by your gross income. The required DTI can vary based on your credit score and your LTV.
If your DTI is above the allowed limit, It means your monthly debt is too high compared to your income. You can ask the lender to calculate the impact of paying off some debt from your cash-out amount. This means that the lender will cover the debt (after closing), and you will receive less cash accordingly. You might qualify for the refinance as you lowered your DTI, without paying off debt out of pocket before closing.
- Doing the math
Every refinance transaction costs money. It can often put you in a better position as you lower your interest rate and use the cash for other purposes. When you work with the numbers, sometimes a very appealing scenario will result in you losing money, and vice reverse when a higher interest rate can be convenient. Think out of the box and let the numbers do the work.
For example, lets assume you refinanced and lowered your interest rate. You plan to sell the home in three years, but meantime, you did not have to worry about the closing costs as $4,500 was rolled into the loan, and due to the lower interest rates, your monthly payment was reduced by $100. Did you save money? After three years, your saving totaled $3,600. You did not even break even with the cost of the new loan. Is it convenient? It could be, pending what was your cash-out refinance purpose. You could have covered other debt with high interest or used the cash out for a more urgent matter. What if you remained at the same interest rate or even higher, and because of the new rate and Lender’s credit, you did not pay any closing costs. As you plan to hold the home for a certain amount of time, compare the new monthly cost for the length of time staying in the home, to determine in which scenario you lose less money. You want the cash back, but you also want to have as much money as possible when selling the home in three years. Do the math.