Refinancing a loan can be a hugely beneficial option for current home-owners. Refinancing is often done for any number of reasons including debt consolidation, to reduce risk in a current loan, to free up cash, or to take advantage of improving interest rates.
One, of many, refinancing option is the Cash-Out Refinance.
A Cash-Out Refinance is usually sought by homeowners, for their current property, once their home or property has built some equity. A loan is taken out for more than what is currently owed, the home is used for collateral, and the borrower gets the difference in cash.
A Cash-Out Refinance pays out the original loan, and replaces it with a loan for a larger amount. The most common reason for a homeowner seeking a Cash-Out Refinance is to make improvements on their homes, or to pay for college tuition.
In most cases, borrowers have the freedom to do as they wish with the loans: Make improvements on a home thereby increasing the long-term value of the home; buying a car; paying off credit card debt; etc. This is different from a Home Equity Loan (HEL) in that a HEL is a separate loan and will exist on top of your first mortgage. A Cash-Out Refinance replaces your original mortgage, and is usually, though not always, done at a more favorable interest rate.
Interestingly, a Cash-Out Refinance is not a taxable event, so many investors will take advantage of this tool in their arsenal. Also, many lenders have higher standards for Cash-Out Refinancing than conventional loans, or even Home Equity Loans.
Cash-Out Refinance in Practice
To give you a real life example of a cash-out refinance mortgage, assume Linda purchased her home 20 years ago for $200,000. If you fast forward to today, she would like to make some improvements to her home. For instance, she would like to replace her flooring with hardwood floors, update her bathrooms, and totally gut her kitchen. Linda expects the total cost of renovations will be about $75,000. Linda has accumulated equity value in her home, which resulted from paying down the principal balance of the mortgage as well as through the appreciation of her home’s value. This gives her the option of using a Cash-Out Refinance to fund her home renovations.
In this case, Linda would ask for a Cash-Out Refinance of $175,000 to cover the cost of renovations. She still owes $100,000 on the original loan, so the first $100,000 of the $175,000 would towards the repayment of the original loan. Linda will receive the remaining $75,000 in hand to use as she wishes. Now, rather than a loan of $100,000 (the remaining balance on her original home loan), she has a single loan of $175,000 with cash in hand to cover the cost of the improvements.