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Is a cash-out refinance a good idea?

If you need money for debt consolidation, home improvements or an investment, a cash-out refinance may be an option for you. If you have sufficient equity, you can apply to refinance your existing mortgage, and at the same time take out cash equal to a portion of your equity in the home and then add that amount of cash to the new loan.

Qualifying for a cash-out refinance

A cash-out refinance, like any other mortgage refinance, requires an appraisal of your property and an evaluation of your financial circumstances. You must have sufficient income and assets to afford the new home loan, with a debt-to-income ratio of no more than approximately 30 percent for the new housing payment, including principal, interest, insurance and taxes. In addition, you will need good credit. The lowest interest rates are typically reserved for people with a credit score of 720 or 740 and above. If your credit score is 620 and under, you may have a difficult time qualifying for a cash-out refinance.

How much cash can you get out?

The amount of cash you can get out depends on the appraised value of your property and the balance of your current home loan. Freddie Mac, for example, allows you to borrow up to 80 percent of the home value on a cash-out refinance. So if your home appraises at $200,000 and you owe $120,000 on your existing mortgage, you have $80,000 in equity. The maximum you could owe on a Freddie Mac cash-out refinance would be 80 percent of $200,000, or $160,000. Since you already owe $120,000, you could cash out as much as $40,000 as long as your total loan balance doesn't go over $160,000.

Waiting period for cash-out refinance

Most mortgage lenders require you to have at least one year of on-time mortgage payments on your existing home loan before approving a cash-out refinance. In a normal housing market, few homeowners would have enough equity in their home anyway within the first year or two of homeownership to make a cash-out refi worthwhile. But if you made a large down payment (25 percent or more) you could be eligible for a cash-out mortgage refinance after one year.

Cash-out refinance and tax deductions

As with most mortgage loans, interest payments on the cash-out refinance loan are generally tax deductible, but you should consult a tax expert to be certain of your individual tax circumstances.

Establish your goals for a cash-out refinance

Before signing an application for a cash-out refinance, be sure to evaluate all the ramifications of a home refinance. Consider your reasons for wanting the cash from your home equity and make sure you understand the consequences of reducing the available equity in your home. In real estate markets with declining, stagnant, or slowly rising home sale prices it could take years for your home value to increase enough for you to recoup your equity.

  • Debt consolidation. If you opt to use the equity in your home for debt consolidation, stick to your budget and don't immediately begin acquiring new debt. Carefully develop a spending plan that includes your new mortgage payment to make sure it is affordable.
  • Home improvements. If you choose a cash-out refinance for home improvements, depending on the improvements you make, you could rebuild your equity quickly.
  • Down payment on second home. Another option is to use your cash-out mortgage refinance to generate a down payment for a second property.

Researching refinance options

As with any other mortgage refinance, a variety of loan choices are available, including a fixed-rate mortgage loan for 15 or 30 years (or some other term) and an adjustable rate mortgage (ARM). Ask a mortgage lender to explain your home loan options when you are refinancing to determine which mortgage will meet your needs.

Homeowners who are ready with established goals, a budget that includes the new mortgage payment, a list of questions about their cash-out refinance, and an understanding of the implications for their taxes will be better prepared to choose the home refinance that is right for them.

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