What is Cash-Out Refinance?

What is Cash-Out Refinance and its Benefits and Drawbacks?

Before availing the benefits of cash-out and lower interest rates, it is important to know what is cash-out refinance and the precautions one should take while opting for it. Read on to understand some crucial aspects of the same.
WealthHow Staff
Last Updated: Jun 3, 2018
Cash-out refinancing refers to a mortgage transaction, through which a person can borrow money over a pre-existing lien, generally reducing the higher rate of interest for repayment.
For example, suppose one owes $90,000 on his home, for which the current value in the market is $140,000. He also wants $20,000 in cash to spend on some urgent requirements. With the refinancing scheme, he can cash-out the required money and renew his loan at a lower interest rate.
In that way, he gets the required sum of money in addition to the new interest rates, as well as attractive tax benefits. Cash-out refinancing is mainly used to pull-out equity from the borrower's home and provides an alternative for home equity loans.
There are two ways a borrower executes a cash-out refinance. He either opens up a Home equity line of credit (Heloc) or refinances the existing mortgage into one or two loans. Before one gets his loan refinanced and opts for a cash-out, he should be sure of his monetary needs and the running value of equity.
Equity is the difference between the market value of one's home and the money he owes on mortgage, and is used to calculate the maximum amount of money one can avail by refinancing his loan. As refinancing involves taking a larger amount as loan, the new interest as well as credit scores should be calculated before one initiates the process.
Benefits and Drawbacks of Cash-Out Refinance
A cash-out refinance is a good deal for homeowners who need some extra funds for expenditure. This money may be required for college tuition fees, home improvement, vacations, luxuries or purchasing another property. Generally, it also lowers down the interest rates, reducing the amount of monthly installments to be paid.
The money freed up, thus can be utilized for daily expenses or payment of the loan itself. The saved money if utilized prudently for the pay-back of loan, can shorten the term of repayment besides lowering the burden of loan. Several tax benefits on the interest paid can also be availed by the borrowers.
Besides the benefits of cash-out refinance, there are also some drawbacks related to it. As refinancing creates a new mortgage, the borrowers are required to pay certain amount of money in form of fees and upfront closing costs. If the new rate of interest is not lower than the existing one, cash-out refinancing may not serve its best purpose. Apart from these, if the home loses its value in the market, the loss is faced directly by the borrower.
Risks involved in Cash-Out Refinancing
There are however some risks involved when the borrower chooses to refinance his loan. If proper calculations are not done, he may land up paying a larger amount of money, probably in the course of a prolonged period of time. If one opts for refinance in order to clear off his credits, the sole purpose is lost if those credits are not handled prudently in future.
The credit scores should also be kept in mind in order to prevent future hassles while applying for new loans. Cash-out refinances provide a beneficial way for borrowers to access the equity in their homes to get some needed cash, and to refinance the existing loan at a lower interest rate. But an assessment of the risks involved should be made in order to avail maximum benefits from it. The marginal savings should also be taken into account while framing the repayment structure.
The cash-out refinance offers flexibility over the borrower's repayment plan, and allows him to use the cash-out money to meet a diverse range of needs. Besides that, it also conglomerates the new loan amount in such a way, that it becomes easier for the borrower to plan his repayment strategy.