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What is cash-out refinancing, and how does it help you?

What is cash-out refinancing, and how does it help you?

Looking for ways to diversify your investments by buying an investment property or shares? You may be considering refinancing. 

You may even be thinking of renovating, expanding your kitchen or perhaps adding a new room. All of these are ways you can leverage the equity you’ve built in your house and use the cash to build wealth. 

Refinancing your home loan can sometimes also be called cash-out refinancing. This basically means that you’re tapping into your home equity by refinancing your mortgage for a larger one, allowing you to take out the extra money as cash. 

For example, suppose you took out a $400,000 mortgage to buy a property worth $500,000 several years ago. Presently, you’re left with an outstanding debt of $200,000. Assuming that the property’s value has not fallen, you’ve built up $300,000 in home equity. Now, you want to convert $50,000 of your equity into cash to pay for a home renovation project you’ve been planning. 

One of the options that you may be able to consider is to refinance your home loan to access this equity. If you choose this option, you can take out a new mortgage of $250,000. The new mortgage would include the $200,000 outstanding from your original mortgage and the $50,000 that you’ve taken out as cash.

Some lenders will let you access the money as a flexible line of credit instead of a lump sum payment meaning you get periodical payments when needed. Like other mortgages, the typical repayment term offered is 30 years with a choice between fixed and variable cash-out refinance mortgage rates.

Home equity loan and cash-out refinance: What’s the difference?

Cash-out refinance loans, and home equity loans are two different options to leverage the equity you’ve built in your property. 

A cash-out refinance mortgage is a brand new mortgage with a higher loan amount than what you previously owed on your house. Generally, you’ll be able to do a cash-out refinance if you’ve had your property long enough to build equity or its value has risen. 

On the other hand, a home equity loan is a second mortgage that doesn’t replace your existing mortgage. If you’re taking out a home equity loan, you’ll be taking out a second mortgage that will be paid separately, usually at a fixed rate of interest. 

While both the products let you tap into your home equity, cash-out refinances are often cheaper. This is because you’re taking out a new loan, meaning it’ll be paid off first if your property is foreclosed on or you declare bankruptcy.

What is the benefit of a cash-out refinance?

Borrowing cash while refinancing may help pay the deposit for a second property, fund a large purchase, or consolidate debts like credit cards and personal loans. You could also use the money for a home renovation project by opting for a line of credit, which is more suitable if you need the money in instalments. 

With a line of credit, you can borrow and repay the extra money on a need-basis, only paying interest on the money withdrawn by you. Some lenders will also allow you to invest the money in shares or purchase a new business, but this is decided on a case-to-case basis. It may be dependent on the level of exposure a lender is comfortable with. 

How much can I borrow with a cash-out mortgage refinance?

Typically, you’ll be able to borrow up to 80 per cent of a property’s value with a cash-out refinance loan. This means you’ll have access to the cash amount or equity that is the difference between what you still owe and 80 per cent of your property’s value. 

However, most lenders will ask you to state the purpose of the loan when applying to assess their risk. This is because lenders don’t control how you’ll use the funds once they hit your bank account. Lenders want to evaluate if you’re a mortgage holder living beyond your means. 

Your lender wants to be sure about what you’re going to do with the money before approving your mortgage refinance application. Once the money is accessible, you might be tempted to use it for other things, which could make your financial situation worse. 

Lenders also require proof that you’d be able to meet the repayments for a higher amount of debt. They want to minimise their risk while ensuring your new mortgage won’t put you under any financial stress leading to repayment issues. If you think you’re falling behind with your repayments, or looking to refinance to free up some cash for meeting your day-to-day expenses, it might be best to speak with a mortgage broker to work out a suitable option. 

Tapping into your equity may help consolidate your loans, but it might not be an effective strategy for mitigating financial stress in the long run. Also, if you’re extending the loan term, you’ll end up paying more interest, increasing the total cost of the loan. Speaking with an expert can help you make an informed decision.

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This article was reviewed by Personal Finance Editor Alex Ritchie before it was published as part of RateCity's Fact Check process.



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