Cash-Out Refinance To Pay Off Debt

Cash-Out Refinance To Pay Off Debt | What You Need To Know?

by Amrita

Last Updated on December 5, 2023 by Amrita

Paying off debt is a major financial goal for many individuals. With mounting credit card balances, student loans, and other debts, finding ways to pay them off can be challenging. One option that homeowners may consider is a cash-out refinance.

A cash-out refinance is a type of mortgage refinancing where the borrower takes out a new loan for more than the amount they owe on their current mortgage. The difference is received by the borrower in cash, which can then be used for a variety of purposes, including paying off debt.

Table of Contents

In this comprehensive guide, I will discuss the advantages of using a cash-out refinance to pay off debt and how it can benefit homeowners.

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Debt Payment With Cash-Out Refinance

Cash-Out Refinance Example

Assuming your current mortgage has a remaining balance of $150,000 while your home is currently worth $400,000, you would have $250,000 in home equity in this case.

Now let’s assume that refinancing your mortgage means you can get a lower interest rate and equity funds to make improvements to your home, inside or out. So in this scenario you must have at least $80,000 in equity (20 percent of $400,000) to be eligible.

Now let’s say your exterior improvement budget is $150,000 and you basically decide to refinance the remaining $150,000 in the mortgage. And here you take out $170,000 in cash for a new loan amount of $320,000.

Here, you are charged 1 percent of that amount ($3200) in closing costs and you end up with $166,800 in equity funds. It can be used to add value to your home by adding siding, landscaping, a deck or other improvements.

Learn More: Is Refinancing Your Mortgage Without Closing Costs A Good Idea?

Cash-Out Refinance Rates

Cash-out refinance rates can vary greatly depending on the borrower’s circumstances. Generally, those with higher credit scores and lower loan-to-value ratios will qualify for the best interest rates, while borrowers who borrow more than 70% of their home’s value may pay a rate 0.125% higher; if they borrow 80%, they may end up paying a quarter percent higher rate.

Furthermore, the more equity borrowed from a home, the higher the interest rate will be. Therefore, it is important for borrowers to assess their own financial situation and consider all of these factors when deciding whether to get a cash-out refinance loan.

Advantage Of Cash-Out Refinance To Pay Off Debt

1. Lower Interest Rates

One of the main advantages of using a cash-out refinance to pay off debt is the potential for lower interest rates. Many credit cards and other types of debt have high interest rates, which can make it difficult to pay them off quickly.

By consolidating these debts into one mortgage payment with a lower interest rate, homeowners can save money on their overall interest payments. This can also lead to lower monthly payments, making it easier to manage debt and potentially pay it off faster.

2. Tax Deductibility

Another advantage of using a cash-out refinance to pay off debt is the potential for tax deductibility. Unlike credit card interest, which is not tax deductible, mortgage interest can be deducted from your taxes if you itemize your deductions.

This means that by consolidating your debts into a mortgage, you may be able to deduct the interest you pay on that loan from your taxes. However, it is important to consult with a tax professional to determine if and how this may apply to your specific situation.

3. Improved Credit Score

Cash-out refinance can also have a positive impact on your credit score. By paying off high-interest debts, you can improve your credit utilization ratio, which is a major factor in determining your credit score.

Additionally, by making on-time payments towards your new mortgage, you can demonstrate responsible financial behavior, further boosting your credit score over time.

4. Simplified Finances

Having multiple debts with different interest rates and payment due dates can be overwhelming and difficult to manage. By consolidating all of these debts into one mortgage payment, homeowners can simplify their finances and have a clearer understanding of their debt situation.

This can also help individuals stay on top of their payments and avoid missing any due dates, which can negatively impact credit scores.

5. Potential for Cash Flow

By reducing your monthly debt payments, you may have more disposable income to put towards other expenses or save for the future. This can also provide a cushion in case of unexpected expenses or emergencies, giving homeowners more financial stability and flexibility.

Cash-Out Refinance To Pay Off Debt: How To Use?

1. Determining Your Cash-Out Refinance Needs

Before applying for a cash-out refinance, it’s important to determine exactly how much cash you need to pay off your debts. This will ensure that you don’t borrow more than necessary and end up paying back more in interest over the long term.

Take the time to carefully assess which debts you want to pay off and create a detailed budget to determine the exact amount you need.

2. Calculating Your Borrowing Limit

It’s also important to understand how much you can borrow through a cash-out refinance. Most mortgage lenders require that you leave at least 20% of your home’s equity untouched, which means your refinance loan will have a maximum loan-to-value ratio of 80%.

This means that the amount of cash you can receive will be calculated by subtracting your existing mortgage loan from your maximum refinance loan amount, which is 80% of your home’s value. Keep in mind that those with VA loans may be able to refinance up to 100% of their equity.

3. Applying for Your Cash-Out Refinance

The application process for a cash-out refinance is similar to that of an original mortgage loan. You will need to provide documentation such as bank statements, tax documents, and other financial information.

Be prepared for an appraisal of your home and a thorough investigation of your finances, including your credit score and reports.

4. Closing Your Loan

Once your application has been approved, the lender will guide you through the final steps to close your loan. This will involve signing documents and paying any required closing costs.

5. Paying Closing Costs

Closing costs for a cash-out refinance typically range from 2-5% of the new loan amount. You can choose to roll these costs into your new loan balance, but keep in mind that they will be deducted from the amount of cash you receive at closing.

6. Receiving Funds and Paying Off Debts

Once your loan has been closed, any debts you elected to pay off will be paid along with your initial mortgage. Any remaining funds will be received through a wire transfer or physical check provided by escrow.

When submitting your application, be sure to inform the lender that you plan on consolidating your debts, as this may improve your chances of approval.

How To Decide If A Cash-Out Refinance Is The Right Choice For You?

Cash-out refinancing can be beneficial in certain circumstances, but it is important to understand how it works and decide whether this option is a good fit for your own financial situation.

  1. The first step in deciding if a cash-out refinance is the right choice for you is to compare the interest rate of your existing debts versus the interest rate of your potential new loan. Cash-out refinancing can help reduce the amount of interest you are paying on multiple debts, but it is important to compare the rates and see if this is a better financial option for you. You should also consider any additional costs or fees associated with taking out a new loan.
  2. The second step is to calculate how much money you will need to finance the new loan, as well as how long it will take you to pay off your existing debts with the cash out refinance. Cash-out refinancing can be a great way to pay off multiple debts quickly, but it is important to consider whether or not this option fits within your budget and timeline.
  3. The third step is to consider the equity in your home. Cash-out refinancing requires you to use your home as collateral, so it is important to consider how much equity you have in your home and whether or not it will support the new loan.
  4. Finally, consider any tax implications associated with a cash-out refinance. Cash-out refinancing can provide significant tax savings depending on your individual situation, but it is important to consult with a financial advisor to fully understand the tax implications before making a decision.

When Might Cash-Out Refinancing Be A Smart Idea? Cash-Out Refinance To Pay Off Debt

When Might Cash-Out Refinancing Be A Smart Idea

Since a cash-out refinance involves your home as collateral, it’s true that lenders take relatively less risk, so refinance rates are still affordable. Therefore, this process of loan can be considered as one of the cheapest ways for big expenses. Most homeowners choose cash out refinance for the following reasons:

  1. To Consolidate High Interest Loans: Refinancing rates are lower than other forms of debt, such as credit cards. You can easily pay off these loans with a cash-out refinance. Here you are given the opportunity to repay the loan with low monthly payments.
  2. Use for investment purposes: A cash-out refinance allows homeowners to purchase a retirement savings or investment property where they gain access to capital in the process.
  3. Use in home improvement projects: Homeowners can use cash-out refinancing for home improvements. They also have the option of deducting the mortgage interest from their taxes if it increases the value of the home substantially.
  4. In terms of child’s college education: Since education is expensive now, it may make sense for you to turn to a cash-out refinance to pay for college. However, the refinancing rate must be lower than the student loan rate.

How Much Cash Can A Cash-Out Refinance Give You?

Home equity can vary by lender and loan type, but generally there is a requirement to maintain at least 20% equity in your home. Here’s an opportunity to borrow 100% of your equity with a VA cash-out refinance if you take out a VA mortgage or are backed by the VA Department.

Also, the general rule is to qualify for a loan of up to 80% of the home’s value. But the smart thing to do is to borrow as much as you need. Also, if there is a balance still outstanding on your original mortgage, you must subtract that balance from the cash you can get.

How Long Can A Cash-Out Refinance Take?

The timeline of a cash-out refinance loan typically takes up to 45 to 60 days for the entire process. After the closing, lenders usually wait three business days before disbursing funds in order to protect their borrowers’ rights. However, if there is a financial emergency, lenders will often consider waiving this right and approving a rapid disbursement.

For those looking to refinance their investment properties or second homes, some lenders are able to approve same-day funding depending on the type of loan and the lender’s policy.

Ultimately, it is important for borrowers to understand that the timeline of a cash-out refinance loan may be longer than expected due to additional paperwork and regulations imposed by various lenders. It is best for prospective borrowers to contact their lenders and discuss their options in order to establish an accurate timeline.

Cash Out Refinance Requirements: How Do I Qualify?

Cash-out refinances offer borrowers the opportunity to receive additional funding based on the equity they have in their homes. To be eligible for a cash-out refinance, certain requirements must be met and these are as follows:

  • You must have a loan-to-value ratio (LTV) of 80% or less for a cash out refinance. This means you would need to have at least 20% equity in your home.
  • The new loan amount cannot exceed the sum of the payoff amount plus closing costs and any applicable prepaids, reserves or escrow requirements.
  • You must have a credit score of 620 or higher to qualify for a cash out refinance, although certain lenders may accept lower scores.
  • You must also provide proof of income and show that you can afford the new loan payment including closing costs and other fees associated with the loan.
  • The property must be an owner-occupied primary residence and cannot be an investment property.
  • For a cash out refinance, the home must have been owned by you for at least one year prior to the loan application date.
  • You also must meet specific debt-to-income requirements which vary depending on the type of loan program you are applying for. Most of the time the maximum Debt-to-Income (DTI) ratio allowed by lenders is 43% or less.
  • Depending on your credit score, you may need to pay for mortgage insurance in order to qualify for the loan.
  • Lastly, most lenders charge additional fees such as an application fee and appraisal fee that will be added into your closing costs.

Do You Need To Pay Taxes On Cash-Out Refinance?

Now a question may arise in your mind that is there any tax on the money received from cash-out refinance? No tax is required here. Because the money received from a cash-out refinance is considered a loan that is not subject to an income tax.

Depending on the type of spending you receive here, you may also have the opportunity to write off the interest you pay.

You’ll be able to deduct interest if you spend money on permanent projects to add value to your home. Here your permanent projects can include anything you need, including replacing a bedroom, roof of the house, etc.

Here’s where it might be your best bet to talk to a tax professional. But again if this cash is used for other purposes like tuition payment or debt consolidation then you may have to draw interest here.

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Cash-Out Refinance Vs. HELOC

HELOCs and cash-out refinance are both great options for homeowners looking to access the equity in their homes. However, there are important differences between the two that should be taken into consideration when deciding which the best option is.

Cash-out refinances offer more attractive rates and less stringent approval requirements since they take the form of a first mortgage – whereas HELOCs typically take the form of a second mortgage and have variable interest rates.

Additionally, with the extended draw period that HELOCs have, they may work better for those who need to access their funds as needed over a long period of time.

Depending on your individual needs and financial situation, one option may be more suitable than the other – so it is important to research your options and make an informed decision.

Cash-Out Refinance Vs. Home Equity Loan

A cash-out refinance, as discussed earlier, involves paying off the current mortgage and taking on another new mortgage. A home equity loan, on the other hand, involves taking out a second mortgage in addition to your original one.

Here, there are two liens on your property in case of home equity loan. So here is the translation of two separate creditors where both are meant with potential claims on your home.

In terms of closing costs, compared to cash-out refinance the home equity loan’s closing costs are generally lower. When you need a substantial amount and it is based on a specific purpose then home equity loan can be good idea and beneficial for you.

But if your goal is to stay in your home for the long term and you can get a lower interest rate with a cash-out refinance, then a cash-out refinance is probably the best decision for you.

Know about both but one thing must be kept in mind that in both cases you have to repay the new loan amount or else you may lose your beloved home.

Alternatives To Cash-Out Refinance To Pay Off Debt

When looking for alternatives to cash-out refinance, there are several other options that you can definitely consider:

1. Personal loan

A personal loan process can make getting a loan easier and faster than a mortgage loan. You can use a personal loan to finance your home improvement, debt consolidation as well as any major purchases or expenses.

Here you are likely to pay off this loan in about five years and may not have to wait for 15-30 years. Based on your credit profile the interest rate may be set which is likely to be higher than a mortgage. But you can still pay less overall here than with a cash-out refinance and get the funds you need within 24 hours.

2. Home equity loan

A home equity loan is not much different than a cash-out refinance. They also allow you to borrow a lump sum. Here your interest rate is unlikely to change since you are not moving your primary mortgage. When you choose a home equity loan, you can expect to purchase 80 percent to 85 percent of the value of your home minus what you still owe.

3. Home equity line of credit (HELOC)

Not requiring a large sum for a large purchase or project can be said to be a good financing strategy. However, going with a HELOC can also be a good idea if there are ideal loan terms.

A HELOC is less expensive than a cash-out refinance where you can count on lower closing costs with an added flexibility in this loan process. Home equity line of credit usually takes less time to close.

You will find no restrictions on the usage of HELOC. And interest payments are levied on the amount of credit used. You can use the funds for annual expenses like college tuition or any other major purpose, including home improvement

4. Reverse mortgage

A reverse mortgage can also be a good alternative that allows homeowners age 62 and older to take cash out of their home. Here there is no hassle of paying the balance as long as the home owner lives and maintains the home. However, the borrower must pay his home insurance, pay their property taxes and maintain the property.

5. Go with other sources of cash

If you’re already involved in high-interest vehicle loans, why not try refinancing them? This process allows you to pay off other debts with your savings as there is a possibility of paying less. You can also look into selling any luxury items you are not currently using to pay off your debt.

Starting a side hustle using high-demand skills or borrowing from family can also be a good decision. Since there is no debt repayments hassle here.

Types Of Cash-Out Refinance Loans Option

Cash-out refinances loans come in three main types and these are conventional, FHA, and VA.

  1. Conventional loans: These are the most traditional type of cash-out refinance loans. They typically require a minimum credit score of 620 and limit you to 80% of your home’s value, though some lenders may offer more or less depending on your situation.
  2. FHA loans: For those with lower credit scores, FHA loans can be an excellent option as they come with lower credit score requirements and allow you to borrow up to 80% of the home’s value. Unlike conventional loans, FHA loans also come with upfront fees that are financed into the loan. here credit scores of at least 600 are typically required.
  3. VA loans: These government-backed loans are available to those who have served or are serving in the armed forces, as well as certain surviving spouses. VA cash-out refinance loans can provide up to 100% of the home’s value but many lenders limit this to 90%. They also charge upfront fees that are financed into the loan, unless you are a veteran with a service-related disability.

Disadvantage Of Cash-Out Refinance

The drawbacks of cash-out refinance can have significant implications for homeowners. It’s important to understand these potential downsides before making a decision. Here’s what you need to consider:

  1. Higher interest rate risks: While refinancing is typically done to secure lower rates, cash-out refinancing can sometimes result in higher interest rates. This can negate the expected financial benefits and make it a less favorable option.
  2. Potential for additional costs: Withdrawing a large portion of your home’s equity may require you to pay for private mortgage insurance (PMI) until you regain at least 80 percent equity. This extra expense can add to your overall borrowing costs and impact your financial situation.
  3. Prolonged repayment duration: Opting for a cash-out refinance to consolidate debt may extend your repayment timeline significantly. It’s essential to avoid spreading debt repayment over several decades when more efficient alternatives exist. For instance, if you’re considering paying off credit card debt, using a cash-out refinance may not yield the expected savings as the repayment term is spread over 30 years.
  4. Increased risk of foreclosure: Regardless of the purpose of cash-out refinance, failing to meet repayment obligations could lead to the risk of losing your home through foreclosure. It’s crucial to exercise caution and only withdraw the amount of cash that is necessary while ensuring it will contribute positively to your financial situation.
  5. Beware of treating your home as a piggy bank: Using home equity for non-essential expenses like vacations can indicate poor spending habits and a lack of financial discipline. It’s advisable to seek help from nonprofit credit counseling agencies if you find it challenging to manage your debt or spending habits effectively.

What Is No Cash-Out Refinance?

No cash-out refinancing is an attractive option for those who don’t wish to add extra money to their principal balance, as it provides the opportunity to reduce one’s interest rate without increasing the principal payoff.

This type of loan involves no additional funds and is based on existing home equity, which makes it ideal for those borrowers who are looking to lower their monthly payments without investing any more money into their mortgage.

Additionally, no cash-out refinancing provides the potential to shorten or lengthen the duration of the loan to better suit the borrower’s needs, giving one more flexibility over their financial situation.

For those seeking to reduce their monthly payments but not wanting to add extra funds, a no cash-out refinance may be an attractive option.

Tips For Staying Disciplined With Your Finances After Taking Out A Cash-Out Refinance

  • Make a budget and stick to it: Cash-out refinances can be a great way for consolidating debt, but can also lead to overspending if you do not have a plan in place. Create a comprehensive budget that accounts for all of your expenses, including loan payments, bills, and food and entertainment costs. This will help you stay on top of your financial goals and ensure that you are able to pay off the debt in a timely manner.
  • Automate payments: Automating loan payments is an easy way to keep you accountable and organized when it comes to paying back your cash-out refinance loan. Set up automatic payments so that you don’t have to worry about remembering when to make your payment each month.
  • Track your progress: Cash-out refinances can be a large loan, so tracking your progress is key to staying on top of the debt and setting yourself up for success. Calculate how much you owe each month and compare it against what you are able to pay off. This will give you a better understanding of where you currently stand, and can help you set more realistic goals for paying off the loan.

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Cash-Out Refinance To Pay Off Debt FAQ’s:

Q.1 : Can you use a cash-out refinance to pay off debt?

A: Yes, a cash-out refinance can be used to pay off high-interest debt such as credit cards and other loans. This strategy is often used by homeowners to free up some of the equity in their homes to pay off existing debts.

However, it is important to understand that taking out a new loan at a higher interest rate than what you currently owe may end up costing you more over time than simply paying off the debt.

Q.2: Do you lose money on a cash-out refinance?

A: Not necessarily. A cash-out refinance can be beneficial if you are able to secure a lower interest rate than what you currently owe on your loans and the closing costs associated with the loan are less than the amount of money you will save in interest over time.

However, it is important to consider all of the potential risks associated with taking out a new loan, such as the potential for a higher monthly payment.

Q.3: Why is a cash-out refinance risky?

A: A cash-out refinance carries the risk of reducing equity in your home, increasing monthly payments and potentially increasing the total amount of interest paid over the life of the loan. Further, if a homeowner is unable to repay the loan or experiences a financial hardship that makes repayment difficult, they may face foreclosure.

Q.4: Should I consider a cash-out refinance?

A: Whether or not you should consider a cash-out refinance depends on your individual financial situation. It is important to weigh the pros and cons of this type of loan before making any decisions. Additionally, when evaluating whether a cash-out refinance is right for you, it is important to consider your budget and long-term goals.

Q.5: What is the fee for a cash-out refinance?

A: The cost of a cash-out refinance depends on the type of loan you choose and your lender’s fees. Generally, costs for a cash-out refinance include an appraisal fee, title search and insurance, origination fee, and escrow fees. Additionally, lenders may charge a higher interest rate on a cash-out refinance than on a regular refinance.

Q.6: When is a cash-out refinance a bad idea?

A: A cash-out refinance can be a bad idea if the homeowner does not have sufficient income to make monthly payments on the new loan, or if the interest rate is significantly higher than what was offered in their original mortgage.

Additionally, refinancing to cash out equity may not be worth it if the homeowner plans to move soon as they may not recoup their costs when selling the home.

Bottom Line: Cash-Out Refinance To Pay Off Debt

Overall, cash-out refinancing can be a great way to pay off debt and free up some extra cash in the process. However, it is important to consider all the factors discussed above before deciding if this option is right for you. Cash-out refinancing can provide significant savings, but it is important to make sure that the financial decision is right for your current and future situation.

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