By: Loans Canada
A mortgage is one of the best ways to purchase the property of your choosing. It can also help you to access and benefit from a slew of different financing options. Whether you’re looking to use a basic loan to buy your house over time or to dip into the equity you’ve accumulated, homeownership is certainly a step in the right direction.
In this article, we’re focusing on one of those options in particular, which is known as cash-out mortgage refinancing.
What is Cash-Out Mortgage Refinancing?
Essentially, the process involves applying for a larger loan that’s then used to pay off and replace your existing mortgage. Afterward, you would receive a cash amount equal to the difference, which you can then use to cover various expenses.
There are two types of cash-out mortgage refinancing:
- Traditional Cash-Out Refinance – This financing allows you to access a sum of liquid cash and finance whatever you’d like with it, even renovations and other less necessary household expenses.
- Limited Cash-Out Refinance – Although you can dip into a similar amount of money, you’ll only be permitted to use the funds to cover specific, more necessary expenses, such as closing costs or other debts.
How Does Cash-Out Mortgage Refinancing Work?
As mentioned, cash-out refinancing is different from the normal mortgage process because whatever money you’re eligible for will be deposited into your bank account in one lump sum shortly following the loan’s approval. In addition, you’ll need to have some equity in your home in order to qualify.
Before you apply for cash-out refinancing, consider this:
- Most mortgage lenders will approve your loan once you have purchased or built up equity for at least 20% of your property. However, they will usually cap your cash-out limit at 80-90% of whatever equity is available.
- Once the loan amount is set, your original amortization schedule will be reformatted, often allowing you to adjust in your repayment plan.
- Your new mortgage amount will increase with every dollar you borrow. For instance, if you initially had a $400,000 mortgage and you borrowed $100,000 from your equity, your current mortgage would increase to $500,000.
- The final conditions of your repayment plan will depend on how much you’re borrowing, how healthy your finances are, and which lender you apply with.
Pros and Cons of Cash-Out Refinancing
Remember, cash-out refinancing is just one way to refinance your home and may not actually be the right choice for your situation. In fact, there are a few positive and negative aspects about the process that could change your mind:
Pros
- It can be a quick way of consolidating property taxes, closing costs, high-interest credit card bills, tuition fees, and other debts.
- If you have good credit, solid finances, and apply when mortgage rates have gone down, you could end up with a lower interest rate than a home equity loan or HELOC.
- Most lenders will permit you to choose the length of your repayment term and the size of your payments.
- By using the cash for home repairs, additions, or renovations, you could add significant value to your home.
- If you use the cash for your unpaid debts, you may be able to save some money in interest. Plus, any good payments should gradually improve your credit.
Cons
- If mortgage rates increase before you choose to refinance, your new interest rate could be higher than your original mortgage.
- Your new payment plan might be unaffordable. For example, the closing costs alone could add up to 2%-6% of the final loan balance. Not to mention, you could end up with larger payments and longer amortization.
- If you borrow 80% or more of your equity, you’ll need to purchase private mortgage insurance annually, which is about 0.5%-3% of your total loan amount.
- The new loan will be secured by your equity. So, if you default on too many payments, you could risk losing your home to foreclosure.
Cash-Out Refinance vs. Home Equity Line of Credit (HELOC)
Like cash-out refinancing, a HELOC is secured against your home and also allows you to borrow from to 80-90% (often 85% maximum) of your available equity.
However, there are a few key differences, such as:
- A HELOC involves a revolving credit limit. Rather than a cash amount, your mortgage lender will provide you with a card that allows you to make charges to the line of credit.
- You’re assigned a “draw period” of about 10 years maximum, during which you can pay for whatever you want and make monthly balance payments.
- Like a credit card, you can also make partial or minimum payments to avoid penalties, which is not the case with a loan.
- A HELOC does not replace your original mortgage. Instead, it gets placed in the second mortgage position until your first mortgage is paid in full.
- Most HELOCs have variable interest rates that change according to Canada’s prime rate, whereas cash-out refinances usually have fixed rates.
- A high variable rate, coupled with the interest you’re still paying on your current mortgage can end up being more expensive than cash-out refinancing overall.
Cash-Out Refinance vs. a Home Equity Loan
A home equity loan is more comparable to cash-out refinancing because it would also allow you to dip into 80-90% of your home’s total value. In addition, you’ll receive a lump sum of cash in your bank account, a modified repayment plan, and a fixed interest rate. Then again, a home equity loan has a few differences of its own, such as:
- Until it’s in the first position, your home equity loan would once again qualify as your second mortgage, leading to two sets of payments every month.
- Interest rates are often higher and more expensive overall, especially if you have two loans on the property.
- Many lenders will cover most of, if not all, of your mortgage closing costs, which generally won’t happen with cash-out refinancing.
- The average repayment terms only last around 15 years, whereas a cash-out refinance can be extended to over 30 years, if the borrower is qualified.
Which Home Equity Option Should You Choose?
Now that you’re well versed in these three home equity products, it’s time to decide when each one works best for your living situation:
Choose Cash-Out Refinancing When…
- You’re trying to consolidate high-interest debts (credit cards, etc.)
- You need to pay for years’ worth of general home maintenance
- The interest you save outweighs the associated fees
- You want a more adjustable repayment plan
Choose a HELOC When…
- You wish to keep the terms of your current mortgage
- You prefer flexible monthly balance amounts, instead of set loan payments
- You’re comfortable paying a variable interest rate
Choose a Home Equity Loan When
- You want the security of a fixed interest rate
- You can afford an additional set of mortgage payments each month
You’re looking for a shorter repayment period
