There are many situations in which a cash-out refinance may make sense depending on your scenario.
A cash-out refinance means you’re taking out a new loan worth more than your original mortgage. In general, you can borrow up to 80% of your home’s value, but this amount depends on which lender you use. You would then use the new loan to pay off the original loan, and you would keep the remaining cash leftover to do whatever you want with it.
Ideally you’re also acquiring a better interest rate when doing a cash-out refinance, and you’re using this method to strategically help your finances.
A Cash-Out Refinance Example Scenario
Let’s go through an example. Say you took out a $200,000 mortgage on a home and you have a $100,000 balance left on it. With appreciation, now your home is worth $300,000.
If you wanted to do a cash-out refinance, you would generally be able to borrow 80% of the home value, which would be $240,000.
With that $240,000, you can pay off the $100,000 balance of the original loan, pay around $10,000 in closing costs, and have $130,000 left to play with.
Our Cash-Out Refinance Story (for Investment Purposes)
In our scenario, we purchased a home at $120,000. It was an extremely moldy home that nobody had lived in for two years. Because of this, we had to put in $80,000 for mold remediation and renovations for a total of around $200,000 put into the deal.
To fund this we used a combination of our own cash and a private money loan at 8% interest.
After repairing the property we got tenants in paying $2,295/month for rent. With the repairs we brought up the value of the home and the property appraised for $330,000.
Instead of just selling the property and receiving a profit, we did a cash-out refinance, getting a loan for 75% of the value of the home so that we could keep the home as a rental and take out money from the deal.
Closing costs were high at around $10,000. So deducting the fees, we ultimately received a $237,000 check to put in our pockets.
This process took 7 months and essentially let us take out all of the money we put in the deal and then some, and allowed us to keep the property. With the remaining funds, we now have capital to buy more rental properties and repeat the process.
The Misconceptions of A Cash-Out Refinance
Now just to be clear, this cash you’re putting in your pocket is not “free money”. With this process, you’re taking a bigger loan based on your home’s value. Therefore, your monthly mortgage may increase, but you’ll have more money you can use for whatever you would like. You just want to make sure you don’t take on too much debt that you won’t be able to handle.
You also want to make sure you’re not spending the money on things that worsen your financial situation. There are risks to doing a cash-out refinance, so you want to make sure you’re actually using the money to help you improve your finances in some way.
In our case, we like using the cash-out refinance strategy to help us purchase more cash flowing rental properties. However, you could use it to pay off any consumer debt you may have to help you consolidate your debt, or spend it on renovating your primary home.
The Pros & Cons of a Cash-Out Refinance
Here are some of the pros and cons of a cash-out refinance.
Pros:
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- Access a large sum of money: Of course getting a new, large loan means more money you pocket. You could use this to pay off other high interest debt like credit cards, or renovate and increase the value of your home.
- Potentially acquire a lower interest rate: If you bought the home you are refinancing at a high interest rate, you could get a lower rate if rates have dropped.
- Potentially acquire more properties with the extra capital. Many investors use this method to scale their rental portfolios significantly. In our scenario, we fixed a distressed property and increased the property’s value, which allowed us to take out all the cash we had put into the deal. This means infinite returns of cash flow and appreciation, because we now have $0 in the deal as we pulled out all our money from it.
Cons:
- High closing costs: In our scenario, we paid about $10,000 in closing costs which was a large sum of money. However, there’s always the opportunity to roll them up into your loan so you don’t pay them out of pocket.
- Incur larger debt: You’ll take on more debt than your previous amount, and it can be risky doing so. So don’t overleverage, and make sure you’re not using the capital on things that don’t actually improve your finances (for example don’t spend on luxury cars and take on even more debt).
Conclusion
We hoped this helped to understand how a cash-out refinance works as well as the pros and cons of it depending on your situation. Everyone’s needs are unique and my personal story may not be a typical result, so be sure to do your research.
If you’re looking for support on your financial journey make sure to check out Bankrate’s resource to let you compare today’s refinance rates across different lenders. Bankrate produces award-winning editorial content, product comparison tools, financial calculators, objective reviews – all free resources to help you make better financial decisions.
Would you do a cash-out refinance or not on your home? Let me know in the comments below.
