Did you know a cash-out refinance can turn your home equity into cash?

As home prices continue to appreciate and interest rates dip to historic lows, homeowners are able to tap into their home equity more easily. In fact, with a cash-out refinance, you could cash out up to 80 percent of your home equity.

You can use the funds for anything — from debt consolidation to home improvements — but there are some uses that make a whole lot more sense than others.

If you qualify for a cash-out refinance and end up using the money wisely, you can greatly increase your financial portfolio in a shorter period of time. 

How Does a Cash-Out Refinance Work?

A cash-out refinance, just like other types of refinance programs, will replace your existing home loan with a new loan at a lower interest rate.

With a cash-out refinance, your new loan will involve a larger sum than you owe on the home currently. The difference between your new mortgage and your current one — that “extra” money you are financing — will translate to the amount you will get in a check at closing. This forms the cash-out component of the process.  

Here is what your cash-out refinance may look like:

• Current mortgage balance: $300,000
• Refinanced loan balance: $330,000
• Cash-out: $30,000, minus closing costs

Now, remember, you can’t cash out the entirety of your equity with a cash-out refinance. Your lender will require you to leave at least 20 percent equity in your home, limiting the amount you are able to withdraw.

How Much Cash Can You Take Out?

The amount you are able to cash out will depend on the value of your home and the balance on your current loan. The refinanced loan amount will max out at 80 percent of your home’s value.

Let’s say your home is worth $350,000, and you owe $250,000 on your mortgage, you have $100,000 in equity. But you can’t get a $100,000 check at closing. Why?

First of all, your lender will calculate 80 percent of the home’s value ($280,000), which is the  max loan amount for your refinanced mortgage.

When you decide to refinance, the new loan (worth $280,000) will be used to first pay off your existing loan. The leftover amount ($30,000) will be the most you may take out using a cash-out refinance. 

Keep in mind, though, that there will be closing costs. Let’s say you have $5,000 in closing costs; this means your final check will be $25,000.

6 Top Uses For a Cash-Out Refinance

Homeowners can use cash-out refinance loans for several reasons, but there are some that are better than others from a financial standpoint.

Most mortgages come with long terms, so keep in mind that the dollars you borrow will accrue interest over that whole repayment period. That’s why using this long-term debt to finance short-term goals (think: extravagant vacation, sports car) is not the best idea.  

Here are some of the best uses for cash-out refinance funds.

1.     Fund a Home Improvement Project

Funding your home improvement project with a cash-out mortgage refinance represents a good investment. Perhaps you would like to add a master bedroom suite to your home. This could easily cost $100,000 or more. Or maybe you want to remodel your kitchen, which could run you $60,000 or more. Or, if you want a brand new bathroom, this could cost you $50,000 or more.

Despite the high cost of these projects, they add enormous value to your home because you’re enhancing your real estate investment — not just spending cash. For these types of large-ticket renovations, a cash-out refinance is a smart way to finance them. If you have a smaller project in mind, such as finishing a small basement, you’re better off with a home equity line of credit.

2.     Pay Off High-Interest Credit Card Debt

If you have a lot of high-interest credit card debt that has been lingering for years, using your refi funds to pay them off is a wise idea. Because it’s a secured loan, a mortgage offers lower interest rates than personal loans that borrowers use in order to consolidate high-interest debt. 

Credit card debt may accumulate interest at rates topping 20 percent, while your mortgage debt could only cost between three and five percent. This will save you a lot in interest, and lower your monthly payments too.

This strategy isn’t recommended for student loan debt, however, since you generally have other affordable options to refinance student debt — and also because federal student loans come with flexible repayment options that a new mortgage simply can’t offer.

3.     Protect or Add to Existing Investments

A cash-out refinance will enhance your investment portfolio, as several investments pay out much better returns than the cost to borrow against your home. If you’re in need of cash yet don’t wish to sell existing investments, tapping into your home equity is a cheaper option.

Some investment products allow you to also save money on your income taxes, such as socking away money in an IRA or a 529 College Savings plan.

A cash-out refinance will also diversify your holdings and protect against a potential downturn in the housing market.

Always talk about these plans with a trusted financial planner before doing anything.

4.     Buy an Investment Property

You may use cash from refinancing your primary residence to purchase more real estate, such as an investment property or rental property. Real estate builds wealth rapidly, as you can leverage your purchase.

In many cases, homeowners can take a cash-out loan on their homes and purchase a rental property with cash. Then, when they are ready to invest again, they perform a cash-out refinance on their existing investment property to purchase the other one. The result? Robust rentals that are able to produce strong ongoing income.

5.     Buy a Second Home

Don’t want to be a landlord but would like a second home, such as a vacation property? When you put as little as 10 percent down, you could purchase a vacation home for your family.

6.    Protect Your Business Against Emergencies With Cash Flow

If you own an existing start-up or business, a cash-out refinance will serve as an affordable source of emergency capital. It could be wise to cash out your equity before your business encounters any cash flow glitches, threatening your eligibility to borrow money.

What are Some Other Ways to Tap Into Your Home’s Value?

A cash-out refinance allows you to access your home equity while replacing your current mortgage loan at the same time with a new one.

There are some additional advantages to this strategy.

Obtaining a new mortgage allows you to lower your interest rate, transfer to a fixed-rate loan from an adjustable-rate loan, or shorten the repayment period.

However, what if you wish to keep your existing mortgage while at the same time access your home’s value? You will need another loan product.

Your two best options include:

• Home equity loan — Borrow a lump sum amount from your equity via a home equity loan. You will still make your existing monthly mortgage payments, plus add a second monthly payment to cover the new loan.
• Home equity line of credit — Your home’s value will be used to fund a revolving loan that allows you to borrow from it as you need to, then repay, and use again. HELOCs come with variable interest rates.

These loans make the most sense when you have a competitive interest rate loan already for your home OR when you’ve progressed so far into your existing mortgage that beginning again with a new loan just doesn’t make sense.

Wondering if You Qualify For a Cash-Out Refinance?

In order to get cash out of your home, you have to have sufficient equity built up.

Every time you make a monthly payment on your mortgage, you are adding to the value of your home. And as your home appreciates in value, your equity will grow with it.

Your ability to qualify for a cash-out refinance will depend on your credit score and debt-to-income ratio. Generally, you will need to have a credit score of at least 620.

Plus, a cash-out refinance loan means you have to still pay all your closing costs. Because your property is not changing hands, your costs won’t be quite as high but you’ll still need to pay the loan origination fee, an appraisal fee, and your attorney’s fees.

In the end, rising home prices and decreasing mortgage rates put homeowners just like you in a good position to cash out their equity.