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Is it a good idea to do a cash out refinance?

refinance_home_loanUpdated by Craig Berry

Mortgage interest rates seem to have finally caught a break. After a trend consisting of more upward movements than downward ones in 2018, mortgage rates dropped last week to their lowest levels in three months.

According to Freddie Mac, the 30-year fixed rate fell to 4.63 percent last week -- the lowest it's been since mid-September.

Lower mortgage rates are always good news if you're a homeowner, or homeowner to-be. Moreover, lower rates can be great for homeowners who want to tap into their home's equity via a cash-out refinance.

Cash out refinance vs home equity loan

A cash-out refinance is different from a home equity loan or line of credit.

In a cash-out refinance, you refinance an existing mortgage loan with an even larger loan. You can take the difference between the old and new loans and spend the extra money however you see fit.

By contrast, a home equity loan is a separate loan that rests on top of your mortgage loan. It provides a lump-sum of cash, and then you make payments over a fixed term.

A home equity line of credit (HELOC) works more like a credit card. Home equity lines allow homeowners to borrow and repay funds over time.

Most home equity loan programs let you borrow up to 80 percent of your home's value. Some lenders allow you to go up to 85 percent loan-to-value. This is also known as your total loan-to-value (TLTV). This is the combination of your first and second liens as a percentage of the value of the property.

Depending on the bank or mortgage lender, by using a home equity loan or line of credit you may be able to leverage slightly more money from your property as opposed to a cash-out refinance. However, in general, a cash-out refinance may give you a better interest rate and longer available terms than a home equity loan.

How much can I cash out refinance?

While the percentage can vary according to the type of refinance program, lenders typically allow you go as high as 80 -- 85 percent of your home's value for your cash-out refinance. The amount of equity you have and will be able to access when doing a cash-out refinance is determined by the appraised value of your home.

With a conventional loan you can go up to 80% loan-to-value for a cash-out refinance. The Federal Housing Administration (FHA) allows you to go a little bit higher than conventional loans at 85%.

For example, if your home's value is $400,000 and you owe $300,000 on your first mortgage, you have $100,000 of home equity.

However, you won't be able to borrow 100% of your home's value. Using this scenario, if you were trying to maximize the amount of cash you could receive via a cash-out refinance, you would likely opt for an FHA loan. With an FHA cash-out refinance you could access 85% of your home's equity.

Using the same numbers, assuming you don't exceed your area's FHA mortgage limits, you'd have access to $40,000 in equity.

Here's a more detailed example of this cash-out refinance scenario at a loan-to-value of 85 percent:

Before Cash-Out Refinance

$400,000 = appraised value of home

$300,000 = current mortgage balance

$100,000 = existing home equity

After Cash-Out Refinance

$400,000 = appraised value of home

$340,000 = new mortgage balance

$60,000 = updated home equity

$40,000 = cash available to you

Should you do a cash out refinance?

Cash-out refinances aren't right for everyone or every situation.

For example, let's say you only want $5,000 or $10,000 cash. If you pay $5,000 in closing costs just to access this amount of cash, a cash-out refinance doesn't make sense.

Further, if you ended up with a significantly higher interest rate than what you currently have, and you're planning to sell your home within the next year or so, a cash-out refinance may not work well for you.

In some cases, you may be able to do a cash-out refinance and lower your interest rate. This can be a win-win for many homeowners as you're able to tap into your home's equity and get a lower mortgage rate at the same time.

Homeowners may choose a cash-out refinance for a variety of reasons. For instance, cash-out refinances are popular for paying off high interest rate debt.

For example, if you have credit card debt with a higher, non-tax-deductible interest rate, a cash-out refinance could make sense to pay off the debt this way. Just remember that you'll be converting unsecured debt to a loan that uses your home as collateral.

Other times where a cash-out refinance can be used include:

  • Home improvements or renovations
  • Investment purposes or building that nest egg you've been meaning to have in savings
  • Vacation or travel
  • Educational expenses
  • Other large purchases such as automobiles, etc.

Cash-out refinance loans can be ideal for homeowners seeking to tap into their home's equity without selling their home. With today's mortgage rates back into the 4's, along with home values on the rise nationwide, now could be a good time to consider your cash-out refinance options.

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