Certain things in life that are very expensive may require more cash to cover than the majority of us might have in our bank accounts. That’s why many consumers tend to take out loans to cover such expensive costs.
While you can take out a personal loan to cover the cost, people who own homes can consider more low-cost options such as a mortgage refinance. Mortgage refinancing involves replacing a mortgage on a home with a new mortgage, typically with different terms and a lower interest rate than the original mortgage. More specifically, many homeowners may take cash out from the equity in their homes when refinancing to be put toward a large expense, which is known as a “cash-out refinance.”
So, what exactly is a cash-out refinance, and is it something that you can benefit from? Read on to find out more.
Key Points
- A cash-out refinance lets you tap into your home’s equity to cover a large expense.
- With a cash-out refinance, you refinance your mortgage for more than what you currently owe and take the difference in cash.
- You must have at least 20% equity in your home to qualify.
- You can’t borrow more than 80% of the equity you have in your home.
What Is A Cash-Out Finance In Canada?
A cash-out refinance is one of many ways to use your home’s equity as liquid cash to cover the cost of a large expense. If you have enough equity built up in your home (at least 20% of your home’s value), you may be eligible for a cash-out refinance.
A cash-out refinance in Canada works by refinancing your mortgage for more than what you still owe on it and taking the difference in cash, hence the name “cash-out” refinance.
In order to qualify for this financial arrangement, you’ll need to have at least 20% equity in your home. Further, you can borrow up to 80% of your home’s value, less your outstanding mortgage balance.
| What is home equity? Home equity is the difference between what you currently owe on your mortgage and the value of your property. Equity can be built by paying mortgage payments every month, through appreciation, or both. |
How Does A Cash-Out Refinance In Canada Work?
Let’s illustrate how a cash-out refinance works using an example. Suppose your home is worth $600,000 and you owe $300,000 on it. That means you still owe 50% of the mortgage but own 50% of the equity.
In this case, you should be eligible for a cash-out refinance as long as your credit and financial profiles are strong. If the current mortgage rate is lower than the rate you’re paying on your current mortgage, refinancing can save you money while freeing up cash to be used to cover a big cost, such as a home improvement project.
You can borrow up to 80% of your home’s value, less the remaining mortgage balance. In this case, 80% of $600,000 is $480,000, minus $300,000 you still owe. This means you may borrow up to $180,000 ($480,000 – $300,000), in addition to what you still owe.
If you wanted to take out the maximum amount of $180,000, you would refinance for $480,000 (the original $300,000 you still owe plus the additional $180,000 taken out).
Pros And Cons Of A Cash-Out Refinance
There are plenty of benefits to a cash-out refinance in Canada, but there are also some drawbacks to consider. Let’s go over both in greater detail.
Pros
- Larger loan amounts – A refinance usually allows borrowers to access larger sums of money compared to personal loans and other types of loans.
- Low-interest rate – Since the home collateralizes the loan, borrowers are typically given lower interest rates on a cash-out refinance compared to unsecured personal loans or credit cards.
- Longer repayment periods – Some loans may only allow short repayment periods, which can make them more difficult to pay off in a shorter period of time. But replacing your existing mortgage with a longer amortization period will give you more time to repay your loan in full.
Cons
- Interest costs – Since you’ll be starting all over with your housing debt, you’ll also be increasing the interest costs over the life of the loan.
- Closing costs – Mortgages typically require hefty upfront closing costs, which can run up into the thousands of dollars.
- Risk of foreclosure – If you fail to make your larger loan payments, you run the risking of losing your home through foreclosure.
What’s The Difference Between A Cash-Out Refinance And A Refinance?
Both a standard refinance and a cash-out refinance involve taking out a new mortgage to replace your old one. However, a standard refinance doesn’t involve borrowing more than your original mortgage. Instead, your new mortgage will be for the same loan amount as your current mortgage, while your interest rate and/or amortization period may change.
With a cash-out refinance, you would borrow more than your original loan amount. That way, you can take out the difference between the new and old loan amounts in cash. In turn, you’ll increase your mortgage amount, along with other changes.
When Does A Cash-Out Refinance Make Sense?
There are so many reasons why a homeowner may need to get their hands on money and opt for a cash-out refinance. Having said that, some reasons are better than others. Here are some situations when this type of loan makes sense:
- To fund home renovations and increase the value of your home
- To pay down consumer debt if it can help you save money on interest
- To pay for school
- To pay off student loans
- To start or grow a business
- To consolidate high-interest debt
Cash-Out Refinancing Alternatives
As helpful as cash-out refinancing may be, there are other alternatives that you may want to consider before you decide which loan option is right for you:
Home Equity Loans
Also referred to as a second mortgage, a home equity loan allows you to borrow money against your home’s equity without replacing your original mortgage. This arrangement allows you to leave your existing mortgage alone so everything stays as is, including all terms and the interest rate.
Home Equity Line Of Credit (HELOC)
Similar to a home equity loan, a HELOC works more like a credit card. You still borrow against the equity in your home without replacing your original mortgage, but you’ll be given a credit limit against which you can withdraw. You’ll only be charged interest on the money you take out and can continue borrowing again and again as you repay whatever you’ve borrowed.
Reverse Mortgage
If you’re 55 years old or older, you may be eligible for a reverse mortgage. This type of loan allows you to access money from your home equity without the need to sell your property.
Can A Cash-Out Refinance Hurt My Credit?
A cash-out refinance could have a negative impact on your credit score for a few reasons:
- More debt. For starters, you’d be adding more debt to your overall financial profile. A higher amount of debt can increase your debt-to-credit ratio, which may affect your credit rating.
- Hard inquiry from your lender. Another way your credit score could be affected is because of the application process itself. When you apply for new credit, your lender will pull your credit file, which is referred to as a “hard pull“. When this happens, your credit score may dip, though only temporarily.
- Missed payments. Finally, your credit score could be negatively affected by a cash-out refinance if you don’t make timely payments on the loan. Missed payments can have a significant effect on your credit score calculations and drag your score down.
On the other hand, you can use your cash-out refinance as a way to improve your credit score by making timely payments. Since payment history usually holds a lot of weight in terms of credit score calculations, making your payments on time every month can have a positive impact on your credit score.
Is Cash-Out Financing Right For You?
If you’re in need of a loan and have a home with equity built up in it, then a cash-out refinance in Canada may be a legitimate option for you. To find out for sure, speak with a representative from Loans Canada today, and we’ll guide you to the appropriate lender who can provide you with the right loan product that best suits your financial situation.
