Refinancing is getting a new loan to pay for an older loan. With refinance, you get cash proceeds from the new loan after the loan balance for the original mortgage is paid.
The extra cash may be used for anything, but it’s recommended to invest it in something that will give a positive financial return. One common use is for renovation or development of the property. Alternatively, you may use the cash to pay for any high-interest loans you may have.
Refinance loans take advantage of the increased home equity, which represents the home owner’s share in the market value of the property. Equity is what remains from the market value when you deduct the liens, encumbrances, and loan balances.
Home equity increases directly with the market value and inversely with loan encumbrances.
An increase in market value may occur due to developments in the local economic conditions. This is particularly true in localities that experience fast economic growth. There may be an increase in the buying power of the population. There may be an influx in population and an increase in demand for properties.
Real estate normally increases in value over time. Renovations and improvements done on the property will increase its market value. If you have lived in your home for many years, the property’s market value and your equity are now surely higher than when you first moved in.
Payments made on the original mortgage loan and any reduction on the encumbrances will increase the home equity.
How Is Cash Out Refinance Computed?
An example will help explain how a cash out refinance is computed.
Say you have a balance of $2,000 on an original mortgage of $5,000. Your property has a current market value of $10,000 based on a recent sale of a similar property in the neighborhood.
Real estate mortgages are normally computed at a cap of 80% of the property’s market value. You may qualify for a cash out refinance of $8,000. The new loan of $8,000 will pay the remaining balance of $2,000 on the original mortgage.
You will get the remaining $6,000 from the new loan as the cash out portion. Increased home equity will yield higher cash proceeds.
Government-backed mortgages offer a higher mortgage cap than the normal 80% of the property value. You may be eligible for a bigger loan and a larger cash amount under FHA and VA mortgages.
Take note that you will consequently incur closing costs in paying up your original mortgage. You will also have to pay for upfront service fees for the new loan. Finally, you may have to buy mortgage insurance in favor of the new lender.
When Is Cash Out Refinance Advisable?
A cash out refinance is a good option when you already have substantial equity on the property. You can leverage your home equity for personal financial growth.
It is prudent to consider getting cash as an opportunity to invest in a sound financial project. As earlier mentioned, paying out loans that have higher interest rates will yield savings. Renovation and development of the properties will result in increased equity. Investment in trusted stocks and blue chips may also be considered.
Things to Look Out For
The cash out refinance is a new loan with different terms and conditions than the original mortgage. The new interest rate is often lower than the original mortgage. This means that it can sometimes be higher. Always make sure you compare the two.
The new loan will usually be larger than the original mortgage. Even with lower interest rates, your monthly amortization may be larger than what you were previously paying. Take note of this and review the amount against your current income. You may have to respond with changes in lifestyle and spending habits.
The cash may be enticing and tempting, but be wary of putting your property at risk of foreclosure. If you have no intention of investing the cash, you do not need the cash out refinance option. If you don’t have any financially sound project in mind, choose from other refinancing and mortgage tools instead.