Whether you’re planning on making some stylish improvements or necessary repairs, home renovations are a good way to add value to your home and improve your quality of life. Unfortunately, home renovations are quite expensive and most homeowners don’t have enough spare money to finance some heavier projects. Instead of spending months saving up thousands of dollars for a home renovation, many homeowners will use a mortgage refinance.
How Can I Use Mortgage Refinancing?
A mortgage refinance allows you to negotiate new terms for an entirely new mortgage that you can use to pay off an existing mortgage. Most of the time, your new mortgage’s principal amount will equal your existing mortgage’s remaining balance so that you can exactly pay off your current mortgage with the new one. This way, you can replace your existing mortgage with a new rate or term and you will maintain the same amount of equity in your home. Many homeowners think of mortgage refinancing as a way to get a lower mortgage rate or to extend their mortgage term. While these are both excellent ways to take advantage of a mortgage refinance, there is another option called a cash-out mortgage refinance.
Instead of getting a new mortgage with a principal balance equal to the remaining balance on your current mortgage, you can get a new mortgage with a higher principal balance and take the difference as cash.
For example, let’s say you have a home worth $500,000 and a remaining mortgage balance of $300,000. If you needed to make repairs that would cost you $50,000, the principal balance of your new mortgage would be $350,000. Before the refinance, you would have owned $200,000 in home equity, but with the new mortgage, you only own $150,000. This means you would have to repay the extra $50,000 as part of your new mortgage, but you would still own the home and be able to live in it. You can use this extra cash for anything you like, but in most cases, this large sum is best invested back in your home because you’re taking it out of your home equity.
How Much Can I Get With a Cash-Out Mortgage Refinance?
Most lenders let you take out a loan equal to 80% of your total home value. Since you have to repay your existing mortgage before withdrawing cash from your new mortgage, the maximum amount of cash you can get with a cash-out mortgage refinance is 80% of your home value minus your existing mortgage balance.
In our above example, you would be eligible to get $100,000 in cash because the old mortgage balance of $300,000 and this new cash would add up to $400,000, which is 80% of the $500,000 home value.
While it is conventional for lenders to offer up to 80% with cash-out mortgage refinances, your maximum amount varies based on your credit history, financial circumstances, and type of mortgage. FHA refinance loans allow cash-out refinances for up to 85% of the home value and VA refinance loans offer refinances for up to 100% of the home value.
If you plan on using a mortgage refinance, then you should be using it for multiple benefits because cash-out refinances are not as straightforward as you’d like them to be. While you can borrow up to 80% in most cases, our original formula for the cash-out amount did not include the many mortgage refinance closing costs. Unfortunately, refinancing a mortgage has many associated costs that will either add to your principal balance or will have to be paid for out of pocket. Many lenders will roll closing costs into the principal amount, but if you are maximizing your loan-to-value, this amount will have to be subtracted from your cash-out total.
For a $500,000 home, you can expect to pay nearly $10,000 in closing costs with a 20% down payment. Going back to our original example with required repairs of $50,000, you would have to get a new mortgage for nearly $360,000 or $10,000 more to account for closing costs.
Due to the added closing costs, a refinance or a cash-out refinance is only beneficial if you can lower your monthly mortgage payments. This means you’ll need to either secure a lower mortgage rate or extend your mortgage term. With today’s low mortgage rates, securing a lower mortgage rate is very achievable.
When to Use a Cash-Out Mortgage Refinance?
A cash-out mortgage refinance is not a one-size-fits-all solution when you need to finance home renovations. With the added closing costs and restrictions, you should make sure that a cash-out refinance makes financial sense. Generally speaking, you should try to secure a lower mortgage rate. With a lower mortgage rate, you can expect to break even and recoup the extra closing costs during the lifetime of your mortgage. Even though you have to pay extra closing costs, a cash-out mortgage refinance is better than many other options. With a cash-out mortgage refinance, you are using your home as collateral for the loan in case you fail to make payments, so lenders will usually charge you a lower interest rate than you would get with an unsecured loan or personal loan. This means that compared to other loan options, a cash-out mortgage refinance is very smart.
However, keep in mind that low mortgage rates are far from free. If you have any other access to capital where you don’t have to pay interest, then those options are best. You should only consider cash-out mortgage refinancing as one of the many financing tools you have access to. Even if you can get a lower mortgage rate with a cash-out mortgage refinance, it would make more sense to refinance at your current mortgage balance and get the capital elsewhere if it is available. Cash-out refinancing is one of the multiple ways you can extract your home equity as cash. If you refinance now and end up needing the cash later, you can use a Home Equity Line of Credit (HELOC) or home equity loan. These also let you access your home equity, but you will not have to refinance your mortgage and you may pay lower closing costs.
The Bottom Line
Large home renovations can be stressful and you may think that a cash-out mortgage refinance is a simple way to get some quick cash. While there are benefits to a mortgage refinance and a byproduct of it can be cash, you should consider a cash-out mortgage refinance as primarily a mortgage refinance. If you happen to need cash for home repairs while considering a mortgage refinance, then a cash-out mortgage refinance is perfect, but even still, you should consider all your options. It’s always worth spending a bit of extra time now making the right decision rather than paying for it later. A cash-out mortgage refinance is just one of the many real estate tools available to homeowners.