There are certain things in life that are very expensive and 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.
People who own homes may also consider refinancing their homes in order to gain access to money required to cover large expenses. Mortgage refinancing essentially 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.”
Can you afford that big purchase? Find out here.
So, what exactly is a cash-out refinance, and is it something that you can benefit from? Read on to find out more.
How Does a Cash-Out Refinance Work?
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, you may be eligible for a cash-out refinance.
Home equity is basically the difference between what you currently owe on your mortgage and the value of your property. Equity can be accumulated by paying mortgage payments every month, through appreciation, or both.
Read this article for more details about building home equity in Canada.
A cash-out refinance 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, which means you can’t owe more than 80% of the value of your home.
For instance, if you purchased your home a few years back and have been making regular mortgage payments, you should have a certain amount of equity built up in it. And if the value of homes in your area has been appreciating over the years, your equity can be even higher.
Wondering if refinancing a loan would affect your credit score? Click this link for the answer.
Let’s say 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, you may find that refinancing can save you some money while freeing up cash to be used to cover a big cost, such as a home improvement project.
In this case, if you wanted to take out $40,000, you would refinance for $340,000 (the original $300,000 you still owe plus the additional $40,000 taken out).
Pros and Cons of a Cash-Out Refinancing
There are plenty of benefits to a cash-out refinance, but there are also some drawbacks to consider. Let’s go over both in greater detail.
- 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 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 new one at a 15- or 30-year amortization period will give you a longer time frame to repay your loan in full.
What’s the difference between an amortization and a mortgage term? Read this to know.
- 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.
Look here for some information about missing mortgage payments and foreclosures.
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 improvements 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 loan – Also referred to as a second mortgage, a home equity loan allows you to borrow money against your home’s equity without having to completely replace 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.
Trying to refinance your second mortgage? Look at this before you do.
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 withdraw 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, which is a loan that allows you to access money from your home equity without the need to sell it.
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 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.