Home equity – the difference between what you owe on your mortgage and what the property is worth – can be leveraged in many ways. One is by doing a cash out refinance, which allows you to trade equity for cash. A cash out refinance can be an appropriate move for homeowners or entities that own investment properties. It’s also a way to access a lump sum of cash from a property to invest elsewhere.
What is a Cash Out Refinance?
A cash out refinance is when a property owner takes out a new mortgage worth more than their existing mortgage, pays off the old mortgage, and then pockets the difference. The cash they pocket is essentially the difference between what the property owner owes on the former mortgage and what they borrow.
There are rules to a cash refinance, so someone can’t go and ask a lender for any amount they want. The amount one can borrow typically hinges on how much equity is in a property. The lender usually limits borrowing to 80% of the value of a property, but that percentage varies between lenders.
How a Cash Out Refinance Works
The first step to a cash refinance is usually a property appraisal to find out how much the property in question is worth. In an ideal scenario, properties appreciate in value over time. A property’s value can be approximated in multiple ways, including comparing the property to other similar ones in the area.
The next step would be to figure out how much equity is needed and ensure the refinance aligns with one’s financial goals. For instance, you may want to take out a certain amount of equity to renovate the property or pay off high-interest debt. Once clear goals are set, it would be time to shop around for a lender and compare interest rates. Lenders who do cash out refinances include private banks, mortgage companies, and credit unions. Shopping around for the best rate is imperative as interest rates can impact the amount a borrower pays throughout the life of the loan.
Once the borrower chooses a lender they submit a cash out refinance application. Some factors that impact the success of the application include debt to income ratio (DTI), credit score, and how much equity is in the property. Some of these factors can also impact the rate on the loan; when the rate is on the higher end, you pay more interest over time, but a lower interest rate means you don’t pay as much.
Lenders also check the loan to value ratio (LTV) during the application process to help assess risk. This is a percentage that discloses how much is being borrowed relative to the property’s value. A sweet spot for LTVs in a cash out refinance is 80% of the property’s value or lower for most lenders, with the exception of VA borrowers. There are online calculators that can be used to determine the LTV for a cash out refinance.
Keep in mind that when you do a cash out refinance, you’re taking out more than you currently owe. For this reason, you want to be sure you can afford the loan. It’s possible and even likely that a borrower could end up with larger payments than they had with the original loan unless they’re fortunate enough to snag a cheaper interest rate on the new loan.
Example of a Cash Out Refinance
The maximum cash out formula is:
Property value x LTV limit – current mortgage balance = the maximum you can cash out
Assume a property is worth $350,000 and has a balance of $200,000 left to pay.
If the owner was considering doing a cash out refinance for home renovations, the lender may give them 80% of their home’s value since lender’s seldom let borrowers take out 100% equity. Based on the above calculation, a borrower could cash out up to $80,000.
$350,000 x 80% (0.8) – $200,000 = $80,000
When a Cash Refinance is a Good Idea
A cash refinance isn’t right for everyone so it’s important to be clear about the end goal. Some good reasons might include home improvements to improve the property value, using cash to consolidate debt, or pay off debt that is at a higher rate. Some may decide to invest the cash into another income-generating asset. For example, a cash refinance could be used to capitalize on compound interest by investing in the stock market. However, the borrower is taking a risk in this scenario and should consider the perils. Defaulting on the loan could result in foreclosure and serious adverse credit consequences.
