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Cash-Out Refinancing

Cash-out refinancing is no different than regular refinancing in terms of expenses. Where a regular refinance involves a new mortgage with better interest rates and a shorter loan term, a cash-out refinance basically replaces your current mortgage with a larger one as a result of cashing out on your home equity. In return for the cash that you get, both the outstanding mortgage balance and monthly payments will increase.

Common reasons for cash-out refinancing:

  • Vacationing
  • College fees
  • Pay off debt
  • Home improvement
  • Emergencies

Cashing Out on Home Equity

The most popular form of cash-out refinancing is the conversion of home equity - built over a period of time - to cash. To demonstrate how this is done in practice, let's say that your house is worth $500,000 and you currently owe $200,000 on your mortgage. This means that you've already built $300,000 (the difference) worth of equity. A cash-out refinance allows you to borrow money which is then added to the final principal owed. If for instance, you borrow $50,000, the final principal owed on the new mortgage becomes $250,000.

Doing this prolongs the loan period and increases the loan amount, which is why you need to be aware of the risk you're taking.

How Home Equity Line of Credit Works

A home equity line of credit (HELOC) is simply the available credit you can derive from your home equity which you've built over a period of time. You can use your home equity like a credit card. HELOCs are open-ended; whether you add to it or deduct from it, your mortgage balance will move in the opposite direction. Lenders will usually issue a limit that determines how much of that credit you'll be able to use without additional charges.

Using the same home equity figures from the previous example: you have $300,000 of home equity that can be used as credit. If we assume that your lender issued a $200,000 cap on your HELOC, you can use any amount of your choice within that limit to be allocated towards paying the outstanding balance on your mortgage. However, if you use your HELOC for anything unrelated to your mortgage, you're cash-out refinancing at that point; higher incremental loan payments, a longer loan term, and a larger outstanding balance will ensue.

The Differences Between Cash-Out Refinancing and HELOC
Cash-Out Refinancing Home Equity Line of Credit (HELOC)
 Changes the interest rate of the existing mortgage loan.  Does not cause any changes to the rate of the existing mortgage loan.
 Prolongs the existing loan term.  Does not alter the existing loan term.
 Increases the outstanding balance of the existing mortgage.   Decreases the outstanding balance of the existing mortgage if the homeowner decides to allocate credit towards it.

Restrictions on Cash-Out Refinancing

  • LTV Ratio: You can't cash-out refinance if your home's current loan-to-value ratio isn't 80% or less. The lower your LTV, the more options on cashing out you'll have. Using the same figures, the LTV ratio works by dividing the mortgage amount owed with your home's current appraised value: 200,000 ÷ 500,000 = 0.4 (40% LTV).
    Learn more about the LTV ratio here.
  • Appraisal: A good LTV ratio depends on how much your home's market value is. The higher your home's appraised market value, the better your LTV ratio is going to be.
  • Credit score: If your credit score is below 700 once you cash-out refinance, you'll be paying higher interest rates.

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