As you build equity in your home, you may want to turn that illiquid asset into cash. There are several options for doing so, like taking out a second mortgage, home equity line of credit, or securing a cash-out refinance.
A cash-out refinance loan replaces your existing mortgage with a new one for more than you currently owe on your home. Your lender then pays the difference between your old mortgage and your new one — in cash — for you to spend on home improvements or other expenses.
But this cash comes at a price: Your new loan will be for a higher principal with different rates and terms than your previous one. This can mean higher interest rates and greater monthly payments.
A cash-out refinance might be right for you if you’re looking to capitalize on your home equity. But don’t act without first understanding the cost of this refinancing option.
Unlike a rate-and-term change refinance — which only changes the rate and terms of your home loan — a cash-out refinance puts money in your pocket.
Like any refinance, a cash-out refinance swaps your old mortgage for a new one. The unique feature of a cash-out refinance is that your loan amount is for more than you currently owe on your existing mortgage. The difference between what you owe and your new mortgage total is where your cash comes from.
For example, let’s say that your home is valued at $400,000.
Your home will serve as the collateral for both the cash and your new mortgage. Your lender will order a home appraisal to evaluate your property and help calculate the total tappable equity.
For a sense of how home equity factors into a cash-out refinance, let’s look at an example of a homeowner who purchased a single-family existing-home 10 years ago at the then median sales price of $169,000. According to the National Association of Realtors, their home is likely to be worth $363,100 today, which means they have built up $225,000 in home equity through the combined effects of appreciation and paying down their mortgage.
Let’s say our example homeowners have a mortgage balance of $137,700. They could refinance their mortgage balance for $200,000 and get $62,3000 in cash ($200,000-$137,000) while maintaining $163,100 of equity ($363,100-$200,000) in their home.
These homeowners benefit from the 10 years of payments they’ve made as well as the staggering effects of home appreciation. They’re like many American homeowners who, on average, have $207,000 of tappable equity in their home.
Not all homeowners are eligible for a cash-out refinance. To qualify, you’ll need to meet the lender’s requirements, which can vary. Typically, though, homeowners will need to meet the following criteria:
The amount of money you receive from your cash-out refinance will depend on the equity you have built up in your home. Your home equity will depend on:
If you’ve paid off a significant portion of your mortgage, your home has appreciated a lot of value, or both, you’ll be able to take out more money.
Most lenders will require you to maintain 20% in equity in your home in order to maintain a loan-to-value ratio of 80%. However, this can vary depending on your loan, lender, and credit score. For example, some VA cash-out refinances permit homeowners to borrow up to 100% of their home’s appraised value.
Another reason to consider a cash-out refinance is because of its tax-friendly benefits. The money you receive from a cash-out refinance is tax-free, because the IRS considers this money to be an additional loan, not true income.
More good news: You can deduct the interest on your original loan balance to lower your overall tax burden. Depending on how you plan to spend your cash-out, you may qualify for additional tax deductions.
If you use your cash-out to make capital improvements on your home, you can deduct the interest you pay on the portion of your loan that you refinance if you make a capital improvement.
A capital improvement is anything that adds value or longevity to your home or adapts it for a different use. Think of these as big-ticket changes to your home, not minor tweaks or fixes like painting walls or fixing an HVAC system.
Examples of capital home improvements include:
The IRS considers the income you make from charging rent on a rental property you own as personal income. So if you used a cash-out refinance to improve, repair, or close on a rental property under your management, you could deduct those expenses from your federal tax return.
You may have the option to purchase discount points as a part of closing on your cash-out refinance loan. These points are fees that you pay upfront to lower your interest rates in the long run.
They’re also 100% tax-deductible. However, the deductions don’t come all at once. Rather than a one-time deduction in the year you closed on your loan, discount point deductions are typically spread out over the lifespan of your loan.
Learn about qualifying for the mortgage interest deduction
This refinancing can be a good option for homeowners who have built up equity in their home and need liquid cash, whether to renovate their home or invest in other areas of their lives. But a cash-out refinance comes with some considerations.
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