If you want to tap the equity in your home, cash out refinancing is one way to go about it. Essentially, you obtain a new mortgage that pays off your existing one and provides you with additional money. Then, you can use that cash to handle other things, like paying off debt, making a major purchase, or covering home improvements. While a cash-out refinance can seem like an attractive option, it isn’t without risk. Before you go forward, here’s a look at why it may or may not be a good idea.
What a Cash Out Refinance Involves
Cash-out refinancing is similar to getting a traditional mortgage. The application process is essentially the same. You contact a lender and submit an application. A lender will review your financial details – including everything from your income statements, tax returns, and credit report and scores — and they decide if you qualify for the new mortgage.
The main difference is that, instead of just requesting enough financing to cover the remainder of your mortgage, you ask for additional money. The new loan is larger than your existing mortgage. Not only does it cover what you owe on your current loan, but it also allows you to receive cash back when it is approved, processed, and closed.
What You Can Do with the Money
With a cash-out refinance mortgage, only some of the money goes to specific things. First, the new lender typically pays off your original mortgage using funds from the new loan. This ensures that the old mortgage is paid in full.
Second, depending on your financial situation, your new lender may require that some of the money goes to pay certain other debts. This is more common if your existing debt load is high (based on your income) and if you have to pay at least a portion of it down to qualify for the loan. When this occurs, the lender commonly pays those creditors directly with some of the loan, guaranteeing that it gets handled.
Finally, any remaining funds are sent to you. Usually, the new lender sends the cash to your bank account as a direct deposit or issues you a check that you can take to your bank. You can use this money on essentially anything you want.
How a Cash Out Refinance Impacts Your Credit
As with any new loan, a cash-out refinance does impact your credit. A hard inquiry against your credit report is part of the process which does affect your score whether you are approved or not. Additionally, you will have a larger mortgage loan on your credit report after it goes through. Finally, since your existing loan is older, the average age of your accounts will change once the new mortgage is reported.
However, how you use the money you receive can also impact your credit score. For example, if you use the additional funds to pay off certain debts, like credit cards or other loans, your credit score will change because of that as well. Your score may go up or down depending on the choices you make.
Is a Cash Out Refinance a Good Idea?
In most cases, a cash-out refinance is only a good idea if you will come out financially ahead in the end. If you use the money for home improvements, the investment could increase the value of your house. Many consider this a solid financial move in the long run. However, it only works out in your favor if the improvements are desirable in the eyes of potential buyers, as that determines the end value of the work.
Using the additional cash to pay off other debts can also be a wise financial decision. You may be able to decrease your monthly bills, improve your credit score, or both. Ideally, you only want to use the money to pay down debts if the interest rate on your new mortgage is lower than the ones associated with the other debts. That allows you to experience the greatest financial benefit, so focusing on high-interest credit cards or loans is the best approach in many cases. However, paying off debts to make your monthly budget easier to manage could still make it worthwhile.
Potential Uses of the Money
There are also other potential uses for the additional money that might be smart, depending on your circumstances. Using the cash to fund further education can be wise if you are reasonably sure that it will boost your income enough to justify the expense. However, there are alternatives for paying for education that could be better financial options.
Similarly, using the money to fund a business venture may or may not be a great idea. Starting a business is always risky, and many fail, so you need to make sure you can still repay the mortgage even if things don’t go to plan.
Using the cash to fund a vacation or large purchase also may or may not be a smart move. That depends on how sound your financial situation is otherwise, such as whether you have a healthy emergency fund in place, are actively saving for retirement already, and don’t have any high-interest debts.
Ultimately, a cash-out refinance can be a good idea, but only if you use the money wisely. If not, then you could be making your financial situation more precarious, and that could lead to hardship down the road.
Have you ever done a cash out refinance? Why did you think it was the right move for you? Share your thoughts in the comments below.
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