A cash-out refinance can open up an attractive pot of money to tap into when times get tough — in theory at least — by giving you access to the equity in your home.
In this article, we’ll explain exactly what a cash-out refinance is, what kind of credit score you’re likely to need to qualify for one, what the right circumstances are for doing a cash-out refinance and more.
Here’s What You Need to Know About Cash-Out Refinances
A cash-out refinance basically lets you get money out of your home like an ATM. But while that may sound great in theory, there are some serious downsides to doing a cash-out refinance that you need to be aware of.
“Remember, this is not free money,” money expert Clark Howard says. “You have to pay it back and the terms of paying it back can get ugly if you stretch it too long.”
Table of Contents
- What Is a Cash-Out Refinance?
- What Is the Purpose of a Cash-Out Refinance?
- How Does a Cash-Out Refinance Work?
- What Kind of Credit Score Do I Need to Qualify?
- When Does It Make Sense to Do a Cash Out Refinance?
What Is a Cash-Out Refinance?
To understand what a cash-out refinance is, it’s first helpful to remember what a plain old refinance is.
A refinance is a financial transaction where you exchange a loan like your current mortgage for a new mortgage, often with a lower interest rate than you had been paying.
The bottom line is that with mortgage rates near record lows, a refinance is a good way to secure a lower interest rate and pay off your housing debt faster if you choose a shorter term for your loan.
Another option is to refinance back into a 30-year loan with a lower interest rate than you have and then just pay extra toward your mortgage every month. That way you can get out of debt faster without being locked into the higher payment you would have if you shortened your loan term to, say, 15 or 20 years.
But a cash-out refinance isn’t quite the same thing as a plain vanilla refinance. In fact, there are a couple of key differences. With a cash-out refinance you:
- Exchange your old mortgage for a new one, but
- A lump-sum payment is paid to you at closing (cash out), and
- You usually pay a slightly higher interest rate because you’re financing more money in the end
The money you get out of the deal with a cash-out refi is the money you’re tapping from your home’s existing equity.
What Is the Purpose of a Cash-Out Refinance?
People commonly use a cash-out refinance as a tool to pay for home improvements. The thinking is you’re tapping your equity, but it’s in the name of building more equity in your home with strategic improvements.
However, we should note that only a few home improvements are really shown to add long-lasting value to your home. Read our piece on The 3 Home Improvements That Are Worth the Cost for the latest data.
But keep this in mind: There is one reason Clark Howard says you should never do a cash-out refinance: To pay down high-interest credit card debt.
If you were to do a cash-out refinance, sure, you could get money out and pay off your credit cards. But you may pay thousands more in the long run on your mortgage because of the higher interest rate.
Moreover, consider this: Credit card debt is unsecured. If you don’t pay your credit card bill, there’s nothing a credit card company can do to you other than ruin your credit and/or harass you endlessly to pay your bills.
But mortgage debt is secured by your home. If you fail to keep up with your monthly mortgage payments, you could find yourself out on the street.
How Does a Cash-Out Refinance Work?
In order to qualify for a cash-out refinance, you need to meet a couple of criteria:
- You need to have equity in your home
- You need to be able to pass underwriting standards
We’ll discuss underwriting standards more in a moment. For now, let’s look at an example of how a cash-out refinance works with your existing home equity.
Let’s say your home is valued at $250,000 and you’ve built up $50,000 of equity through paying down your mortgage. So you have a remaining mortgage balance of $200,000.
You can generally get up to 80% or 90% of your equity in a cash-out refinance. But let’s say you take a more conservative approach and just tap half of your home equity.
That means you can refinance your $200,000 remaining balance and get half of your equity — $25,000 — as a lump-sum payment at closing.
The end result is your new mortgage balance will be $225,000 (which is your original $200,000 balance plus your $25,000 lump sum).
What Kind of Credit Score Do I Need to Qualify?
In order to do a cash-out refinance, you’ll need a higher credit score right now than ever before. MarketWatch reports some lenders are insisting on a minimum credit score of 700 to consider your cash-out refinance application.
Of course, that varies by lender. But because of the coronavirus pandemic, it’s better if you err on the side of having a higher credit score at this time. We’ve got advice on how to raise your credit score fast here.
The increased credit score requirements really serve a twofold purpose: On the face of it, banks only want to put up capital for the most creditworthy customers because of the challenging economic climate right now. That makes good financial sense.
But according to Reuters, there’s another reason why banks want to see a higher credit score on refinances.
With bank employees working from home, it’s taking longer than ever to handle refi requests. So raising credit score requirements is a quick and easy way to limit the influx of applications.
When Does It Make Sense to Do a Cash-Out Refinance?
Clark Howard says doing a cash-out refinance is really only a smart money move in two particular instances:
- To pay for home improvements
- As a cheaper alternative to borrowing for your child’s education
Doing a cash-out refinance is one possible strategy to get money to do home improvements and when you’re considering helping your child pay for college in some instances.
But a cash-out refinance should never be used to pay off credit card debt, no matter how high the interest rate. It’s simply too dangerous to pay off an unsecured debt by taking out debt that’s secured by your home as collateral.
If you’re trapped in high interest credit card debt, your first line of defense should be to get on a budget. Combine that approach with getting a 0% APR credit card to do a balance transfer and you’ll be on your way to tackling your debt.