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If you’ve ever wanted to accomplish a major home renovation or get out from under a pile of debt, you’ve probably thought about tapping your home equity. American homeowners’ median equity was $200,000 in 2022, according to the latest data available from the Federal Reserve Board's triennial Survey of Consumer Finances.
With $200,000, you could certainly check a few items off your wish list. And any loan that’s secured by your home will likely be the cheapest way to borrow, because your mortgage servicer can always foreclose — kick you out and sell the place — if you quit paying your loan.
Your home might also be your largest asset besides your retirement accounts, but tapping those for funds can have negative consequences. It could entail paying income tax at your marginal rate (perhaps 22, 24, 32 or 35 percent) and early withdrawal penalties of 10 percent along with sacrificing years of compound growth. And the median value of a household’s retirement accounts was just $87,000 in 2022, per the Federal Reserve.
A cash-out refinance means you don’t have to touch those retirement funds. Plus, by extending your loan term and, ideally, lowering your interest rate, you might end up with a similar monthly mortgage payment plus money to use however you want.
Before you decide to do it, though, it’s important to understand how cash-out refinancing works and what it will cost you.
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How cash-out refinancing works
A cash-out refinance allows you to borrow more than you currently owe on your home and use the excess funds however you want. If you own your home free and clear, you can do a cash-out refi to access your equity. If you have an existing mortgage, you can do a cash-out refi to take out a larger mortgage that pays off your existing one and leaves you with extra money.
The ability to use the money however you want can get some people in trouble.
“I would advise you to only take cash out of your house if you truly need it and have a defined purpose for it,” said Jennifer Beeston, senior vice president of mortgage lending at Guaranteed Rate Mortgage. “There are some people on social media who are pitching that everybody should take out as much cash as they can from their house. But without a defined purpose, all you’re doing is incurring costs and increasing your monthly mortgage payment.”
Now, the worst-case scenario is unlikely; people don’t end up in foreclosure very often. According to ATTOM, a real estate data provider, foreclosure rates from 2005 through 2024 were as low as 0.11 percent of all housing units (in 2021) and never got higher than 2.23 percent (in 2010, when the housing market collapse was still working itself out).
However, because people tend to do everything they can to keep their homes — which lenders are banking on when they offer those enticing rates — other aspects of your finances could suffer if you don’t think through your decision carefully.
Cash-out refi eligibility: How much home equity do you need to qualify?
No law dictates how much equity you must have or how much of your equity you can borrow against with a cash-out refinance. But as a broad rule of thumb, lenders require borrowers to retain at least 20 percent of their home equity after borrowing against it.
“Generally, the amount of cash you can take out of your house will be the same regardless of lender, as for traditional loans, we are all working on the same loan-to-value and debt-to-income restrictions,” said Beeston.
If you have to keep 20 percent of your equity, then you might need at least 25 percent equity for the loan to make sense. To borrow that 5 percent, you’ll need to have a home that’s valuable enough for it to be worth paying borrowing costs to access your equity. In other words, if your home is worth $400,000, your home equity is $100,000 (25 percent) and you want $20,000 in cash, you have to decide if you’re willing to pay perhaps $5,000 in projected closing costs (typically 1–2 points) on a $320,000 loan and be left with only $15,000 to spend.
What might make such a loan worth doing is if you’re getting a lower interest rate on your existing mortgage in the process. Maybe you owe $300,000 at 7.5 percent interest and when you do your cash-out refi, you’ll owe $320,000 at 6 percent interest.
You can test the math using any of the numerous calculators available on the internet, like this one.
Existing purchase loan
Home purchase price: $400,000
Down payment: 5 percent, or $20,000
Original loan amount: $380,000
Original loan interest rate: 7.5 percent
Loan term: 30 years
Monthly payment: $2,657
New cash-out refinance loan, about seven years later
Home value: $462,500
Current loan balance: $350,000
Home equity: $112,500 (24.32%)
Amount to cash out: $20,000
New loan amount: $370,000 (current loan balance plus amount to cash out)
New loan-to-value (LTV) ratio: 80 percent
New interest rate: 6 percent
Loan term: 30 years
New monthly payment: $2,218
Monthly savings: $439
Closing costs: $5,000 (taken out of the $20,000)
Break-even point: about 1 year
It’s all relative
Multiple factors are at play, so you’ll have to do the math for the specific transaction you’re considering to see whether it makes sense.
Here are a few examples of how different variables can change things:
● If you’re cashing out more equity for the same closing costs, your break-even point will occur sooner.
● If you’re refinancing out of an FHA loan and into a conventional loan, you’ll ditch the mandatory monthly mortgage insurance premiums you’re paying to the FHA, and your break-even point will be even sooner because your monthly savings will be greater.
● If your new interest rate will be 6.5 percent instead of 6 percent, it will take longer to break even.
“It is important to look at all the numbers with your mortgage loan officer before you proceed with a cash-out refinance,” Beeston said. “Sometimes the cost to do the refinance outweighs the benefits of taking the cash out. Make sure you’re working with a lender who will take the time to go through this with you.”
If the break even period is too long because you can’t get a low enough interest rate, then a home equity loan or home equity line of credit might make more sense.
Cash-out refi interest rates and fees
Cash-out refinance rates reflect the risk of owing more money on your home than you do now.
“A cash-out refinance generally is going to have a higher interest rate than a rate-and-term refinance,” Beeston said.
Here are the other factors that will affect your borrowing costs.
Credit score
The lowest rates and fees typically go to borrowers with scores of 780 or higher (this number varies by lender and can fluctuate with economic conditions).
The easiest ways to improve your credit score are to make all your payments on time and to lower your credit utilization, which is the amount of available credit you actually use each month. You can lower your credit utilization by opening a new credit card, requesting a credit limit increase on an existing card, shifting purchases to a debit card, or paying down your credit card balance before your statement is issued. The statement balance is what gets reported to the credit bureaus.
Debt-to-income (DTI) ratio
Your DTI ratio is the sum of your recurring monthly debt payments (including your proposed mortgage payment) divided by your gross qualifying income. It typically can’t be higher than 45 percent to qualify for a cash-out refinance — unless you have six months of cash reserves. You can lower your DTI by paying down debt or increasing your income. (See: Debt: Are you an ostrich?)
Loan-to-value (LTV) ratio
Many lenders require you to keep at least 20 percent of your equity (which is the same as having an LTV ratio of 80 percent) when you do a cash-out refinance. They might offer the best pricing, however, to someone who keeps 40 percent of their equity (an LTV ratio of 60 percent). If you can be flexible about how much equity you take out, ask your lender how your LTV ratio will affect your rate and fees.
Getting loan preapprovals from multiple lenders
Getting a lower rate could save you tens of thousands of dollars over the life of your loan. Reallocate the time you’d normally spend trying to save a few bucks on groceries, shoes, or plane tickets and put it toward comparing mortgage prices instead.
“Make sure you shop lenders when you’re looking at a cash-out refinance,” Beeston said. “You need to shop the lender fee as well as the interest rate and who will actually do the math with you.”
Because mortgage rates can change daily, you’ll be able to compare quotes most accurately if you submit all your applications on the same day — and if you apply for preapproval, which gives lenders enough detail about your finances to give you a firm and realistic offer (or rejection).
When does a cash-out refinance make sense?
Believe it or not, there are loan officers who care about your best interests and don’t just want to close the loan for their own benefit. Look for someone who is experienced and successful, not new and desperate for business.
“Seriously, I probably talk 30 percent of people who want to refinance out of refinancing,” Beeston said. “Refinancing your home to pay off a $5,000 credit card is never the right answer.”
Most cash-out borrowers use the money to pay off other debts, make home repairs, or undertake new construction, according to the Consumer Financial Protection Bureau’s analysis of mortgage origination data from 2014 to 2021. Yet, those who use the money to pay down credit cards often only partially pay down their balances, then let them increase again within months.
A cash-out refi can be a sensible way to borrow when it’s your least expensive option to get the cash you need. For that to be the case, you’ll typically need to be replacing your existing mortgage with a lower-rate mortgage, or you’ll need to be starting with a paid-off home. You’ll also need to put the cash toward long-term investments in your quality of life and net worth, and avoid compromising other priorities — like saving for retirement.
If you’d like personalized guidance on addressing your overall financial goals, reach out to a MassMutual financial professional. They can take a look at the big picture, identify opportunities you may not be aware of, and help you evaluate the potential benefits as well as risks of different financial strategies.
Discover more from MassMutual…
Shopping for a mortgage? Do your homework first
How to refinance your mortgage
Mortgages in retirement: What you need to know
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