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CASH-OUT Refinance

A cash-out refinance replaces your existing mortgage with a new home loan for more than you owe on your house. The difference goes to you in cash and you can spend it on home improvements, debt consolidation or other financial needs. You must have equity built up in your house to use a cash-out refinance.

Traditional refinancing, in contrast, replaces your existing mortgage with a new one for the same balance.

Here’s how a cash-out refinance works:

  • Pays difference of your mortgage balance and home’s value.
  • Has slightly higher interest rates due to a higher loan amount.
  • Limits cash-out amounts to 80% to 90% of your home’s equity.

In other words, you can’t pull out 100% of your home’s equity these days. If your home is valued at $200,000 and your mortgage balance is $100,000, you have $100,000 of equity in your home. Let’s say you want to spend $50,000 on renovations. You can refinance your loan for $150,000, and receive $50,000 in cash at closing.

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THE PROS & CONS OF CASH-OUT REFINANCE

The Pros

  • Lower interest rates: A mortgage refinance typically offers a lower interest rate than a home equity line of credit (HELOC) or a home equity loan (HEL).

  • A cash-out refinance might give you a lower interest rate if you originally bought your home when mortgage rates were much higher. For example, if you bought in 2000, the average mortgage rate was about 9%. Today, it’s considerably lower. But if you only want to lock in a lower interest rate on your mortgage and don’t need the cash, regular refinancing makes more sense.

  • Debt consolidation: Using the money from a cash-out refinance to pay off high-interest credit cards could save you thousands of dollars in interest.

  • Higher credit score: Paying off your credit cards in full with a cash-out refinance can improve your credit score by reducing your credit utilization ratio — the amount of available credit you’re using.

  • Tax deductions: Unlike credit card interest, mortgage interest payments are tax deductible. That means a cash-out refinance could reduce your taxable income and land you a bigger tax refund.

The Cons

  • Foreclosure risk: Because your home is the collateral for any kind of mortgage, you risk losing it if you can’t make the payments.

  • New terms: Your new mortgage will have different terms than your original loan. Double check your interest rate and fees before you agree to the new terms.

  • Closing costs: You’ll pay closing costs for a cash-out refinance, as you would with any refinance. Closing costs are typically 3% to 6% of the mortgage — that’s $6,000 to $10,000 for a $200,000 loan. Make sure your potential savings are worth the cost.

  • Private mortgage insurance: If you borrow more than 80% of your home’s value, you’ll have to pay private mortgage insurance. For example, if you have a mortgage of $100,000 on a home valued at $200,000 and do a cash-out refinance for $160,000, you’ll probably have to pay PMI on the new mortgage. PMI typically costs from 0.05% to 1% of your loan amount each year. A PMI of 1% on an $180,000 mortgage would cost $1,800 per year.

  • Enabling bad habits: If you’re doing a cash-out refinance to pay off credit card debt, you’re freeing up your credit limit. Avoid falling back into bad habits and running up your cards again.

The Bottomline

A cash-out refinance can make sense if you can get a good interest rate on the new loan and have a good use for the money. But seeking a refinance to fund vacations or a new car isn’t a good idea, because you’ll have little to no return on your money. On the other hand, using the money to fund a home renovation or consolidate debt can rebuild the equity you’re taking out or help you get on a sounder financial footing.

Just remember that you’re using your home as collateral for a cash-out refinance — so it’s important to make payments on your new loan on time and in full.

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Refinance Required Documentation Checklist

If your loan is not government-backed, you will need to produce all of the standard documentation. Review this checklist to make sure you have all of the required documents to apply for mortgage refinancing.

1. Pay Stubs

When applying for a home loan refinance, your lender will need proof of income. Lenders want to ensure that you have the financial means to pay off your new mortgage, as well as any other long-term debts (such as car loans) or other living expenses.

As a result, borrowers are generally required to submit recent pay stubs from the past 2-3 months. So, be sure to make copies of all these documents and keep the originals in a safe place.

If you are self-employed, your lender may also require a little more information to verify your source of income. Copies of your last two federal income tax returns, as well as profit-and-loss statements may be requested for review.

2. Tax Returns and W-2s and/or 1099s

To provide further proof of employment and income, be sure to prepare copies of your last W-2 and/or 1099 statements and tax returns. Typically, lenders will ask for two years’ worth of information.

Remember, a W-2 form is used by company employees. This form shows a person’s income and how much of the money was taken out for taxes. In contrast, a 1099-MISC is used by independent contractors or the self-employed. This form shows a person’s income, but does not show how much money was taken out for taxes.

These documents are important because they not only verify your salary but also show trends in your earnings, as well as details about investment gains or losses. Most importantly, this information can affect your total income level and subsequent loan approval amount, as calculated by the lender.

3. Credit Report

Before you are approved for a refinance, lenders will perform a credit check. While each loan program may have its own minimum credit score requirement, it’s always better to be safe than sorry. So, even if you are just considering refinancing, it is never too early to check all three FICO scores to make sure that you’re on the right track.

By taking this precautionary step, you have the opportunity to review your credit rating before your lender does. And, you get the chance to take care of any necessary credit repair work. This means getting rid of those extra credit cards you don’t really need, paying down your account balances and making sure you pay all your bills on time from this point forward. Remember, the best refinance rates are almost always reserved for the borrowers with the best credit.

4. Statements of Outstanding Debt

Even though your lender will be able to see your existing debts via your credit report, you will still have to provide documentation detailing your current outstanding financial obligations. You will need to gather account statements on all remaining debts, including your existing mortgage, home equity lines of credit, car loans and student loans.

5. Statement of Assets

Just as when you first purchased your home, your lender will want to verify that you have enough cash in your savings accounts to cover any out-of-pocket closing costs and at least two months’ worth of mortgage payments.

Therefore, copies of statements for saving accounts, retirement account, stocks, bonds and certificates of deposits will also be needed. All of these documents will provide proof of any additional assets you own in addition to your regular salary.

The advantages of collecting these documents before shopping for lenders is twofold: it not only allows borrowers to truly assess their refinancing readiness, it is also likely to help them score a better refinancing deal later on down the line.

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