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What is a Cash-Out Refinance and How Can It Help You?

There are many benefits to building equity in your home. For one, it helps to build value in what is most people's largest asset. So, if they have to sell their home, they will have a good amount of money built up in it that they can then take to make an investment or make a down payment on another home.

In addition, homeowners can tap into the equity they've built in their home while they're still paying it off. Through what's known as a cash-out refinance, homeowners may have the ability to not only lower their monthly payments but also get a lump sum of cash to use for any number of purposes.

Let's take a look at what a cash-out refinance is and how it can help you.

How a Cash-Out Refinance Operates

 

A cash-out refinance is just one type of refinance that you can do when you own a home. Like all refinances, a cash-out refi will wipe away your current mortgage and give you a new one. 

The new mortgage will come with new terms, including the length and interest rate. You may even opt to refinance with a different mortgage company than the one you have your current mortgage with.

While some refinances will include a new loan that's worth less than what you currently owe on your home, a cash-out refinance will work the opposite way. You'll be financing more than you currently own on your home, and then take the difference between the two numbers as a lump sum cash payment.

To see how this works, let's assume your home is currently valued to be worth $250,000, and you have $150,000 outstanding on your current mortgage balance. You could then decide to refinance and take a new mortgage for $200,000 and take the remaining $50,000 in value as a cash payment.

Most lenders who offer cash-out refinances will require you to still have at least 20% equity in your home -- meaning your new mortgage amount can't exceed 80% of your home's value. In the example above, you'll have exactly 20% equity.

There are some downsides to a cash-out refinance, including the fact that your mortgage will start over for 30 more years (in most cases) and your monthly payment may go up since you're financing more money.

However, there are many benefits of a cash-out refinance. Here are some of the main benefits.

Consolidate Debt

If you have a good amount of revolving debt at high interest rates, a cash-out refinance could help you pay all of that off quickly. High credit card balances can result in you paying a lot of money in interest each month.

If you have three credit cards with high balances that each have an interest rate at 15%, for example, you could use a cash-out refinance to pay these all off. You would take all or a portion of the cash out to immediately pay off your credit cards.

Then, instead of paying 15% interest on this outstanding debt on credit cards, you could pay it off at a much lower rate that will typically be less than 10%. Even when mortgage rates are high, they are usually considerably lower than that of credit cards.

Improve Your Credit Score

When you use a cash-out refinance to consolidate your debt, you will have the ability to improve your credit score. That's because you'll be freeing up available credit, which will increase your ratio of credit utilization.

This is one of the factors that is used to determine your overall credit score. Eventually, this could lead to a large savings in money if you need to borrow money in the future. 

In addition to improving your credit score and saving on interest by consolidating debt, a cash-out refinance will also simplify your bills. You can pay just one monthly bill for all your debt rather than multiple bills.

Fund Home Improvements

Everyone dreams of home improvements, but they can be quite expensive. With a cash-out refinance, you can get the money you need to make improvements to your home. 

You can fix existing problems, re-paint your house or make new additions such as an additional room, a new shed, a pool or new flooring. The possibilities are endless.

There are two main benefits of funding home improvements through a cash-out refinance. First, you'll be saving money on interest, as other options to finance these improvements often have much higher interest rates.

And second, you'll be using the cash-out refinance to increase the value of your home. Home improvements often result in a higher value for your home, depending on the improvements you make. So, in a way, you'll be using the cash-out refinance as a way to improve the value of your home while also enjoying the improvements while you still live there.

Pay Big Expenses Such as College

Another option would be to pay for a child's college tuition, or help them in that regard. College is getting more expensive by the year and so, too, are the typical loans that are used to finance higher education.

About 20 years ago, the typical college loan programs such as private student loans and federal PLUS loans had extremely low interest rates. That has changed in recent years, though, so much so that the interest rates for most cash-out refinances are much lower.

You might be able to save multiple points in the interest rate alone, making your monthly payments on the loan considerably lower with a cash-out refi compared to traditional student loans. What's more, most traditional student loans have a repayment period of 10 years, while cash-out refinances are usually either 15 or 30 years -- allowing you to spread out the payments even further.

Create Tax Savings

Depending on what you use the funds for, you could take advantage of tax deductions the IRS makes available. For example, if you take your cash-out refinance and use it for home improvements that meet the IRS' requirements, you might be able to deduct the interest that you pay on the loan come tax time.

As always, if you want to see all the tax advantages that might be available to you through a cash-out refinance, you should talk to a tax professional first.

 

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