Cash-Out Refinance: What is it?

For those who are looking to build their wealth through buying their first investment property, or even for those that have an existing portfolio of investment properties, it’s important to periodically assess how you can continue to unlock equity that is sitting unused in your current properties, especially in a changing economic landscape. It’s always important to constantly re-evaluate your current mortgages and see if there are any refinancing opportunities you could access to your benefit.

As we have covered, refinancing is when you replace an existing mortgage with a new one, and this strategy could be used as a powerful tool to allow borrowers to access more favorable financing terms, such as decreasing one’s monthly mortgage payments, locking in a lower interest rate, or rearranging the duration of the loan. When interest rates are increasing, however, it is generally considered to be the wrong time to refinance, as the benefits of refinancing are not as abundant as when interest rates are declining.

With all that said, there’s another reason to refinance your current mortgage — and that’s to access cash from the equity in your property. This is called a cash-out refinance.

What is a Cash-Out Refinance?

A cash-out refinance, or a cash-out refi, is a type of mortgage refinance that takes advantage of the equity you’ve built over time and gives you cash in exchange for taking on a larger mortgage. Put very simply, with a cash-out refi, you borrow more than you owe on your current mortgage and pocket the difference.

With a standard refinance, the borrower would never actualize any cash in-hand, they would just see an alteration of the terms in their mortgage. This is one of the main reasons why a cash-out refi may make sense even when interest rates are rising — in certain situations, paying a higher interest rate or extending the duration of your loan might be worthwhile if you’re able to reduce your monthly payments and utilize your dormant equity as cash, especially if you’re ready to deploy it into a new investment.

Now, you might be wondering, what is equity? And how do I gain equity in a property?

In real estate, equity refers to the amount of a property that you own. There are two main ways in which you can gain equity in your property:

1. Your property increases in value.
2. By paying down your mortgage principal through your monthly mortgage payments.

If you bought a property with cash, or have paid off the whole mortgage on property, the value of the whole property is considered to be equity that you own. However, if you took out a mortgage on a property, your equity refers to the amount of a property’s value that you’ve actually paid off. Every time you make a monthly payment on your loan, you gain a bit more equity in your home — as we like to say, the less you owe the more you own.

The other way you can gain equity in your property is the old-fashioned way — an increase in your property’s value, which can happen through renovations or just a rise in real estate prices in the marketplace.

Being able to tap into this unused cash that’s sitting dormant in a property could become helpful when looking to improve the value of a property through renovations or when looking to make another real estate investment.

Another additional benefit is that a cash-out refi is not a taxable event, so any cash incurred from this loan doesn’t get included in one’s income for tax purposes.

How Does a Cash-Out Refinance Work?

The cash-out refi process is similar to the process that one goes through when buying a new property, as many of the same steps are needed, such as the underwriting and appraisal processes. The amount of money you’re eligible for on your new loan will depend on your credit profile and the loan-to-value ratio.

So you might be wondering, is this a second mortgage? What happens to my initial mortgage?

A cash-out refi is not a second mortgage. When you take out a cash-out refi, you take out a completely new mortgage with new terms for more money than what you owe on your current mortgage — essentially trading in your old mortgage for a new property loan. This new mortgage is then used to pay off the remaining amount on your initial mortgage. Whatever money is leftover after paying off your original mortgage, less the origination fees and closing costs, is cash you get to put into your pockets.

Although the terms of your mortgage start from scratch with the new loan, if your property has increased in value since your original mortgage, you might have access to equity in your property that wasn’t available to you when the property was originally acquired. For many people, property values have increased more than 20% since 2020, thereby increasing owners’ equity in their property.

So for example, if someone owned a property that is worth $500,000, and they had $200,000 left on their original loan, it would mean that their LTV is 40% and they have $300,000 of equity in their home. On a cash-out refi, they might be able to get their LTV up to 65%, which would mean a new loan of $325,000. After paying $25,000 in closing costs and $200,000 to pay off their original loan, this indivudal would have $100,000 of total cash in-hand.

What’s the difference Between a Cash-out Refi and a Home Equity Line of Credit (HELOC)?

There are many different types of loan products one can use when looking to get extra cash, and it’s important to have clarity on the different nuances and benefits of each product. Two common products that are often used to secure extra cash in similar situations are a Cash-Out Refinance and a Home Equity Line of Credit, often referred to as a HELOC.

However, because these two loans can be used in similar situations, many people mix-up these products and mistake one for the other. There are many pros and cons to both and each loan product should be researched more thoroughly to figure out if it’s the right financial move for you. With that being said, we want to briefly explain the main differences between these two types of loans.

First and foremost, a cash-out refi can be used on an investment property while a HELOC can only be used on a primary residence. Additionally, as we mentioned above, a cash-out refi replaces an existing mortgage while a HELOC is just an additional loan.

Furthermore, because a HELOC is a line of credit, you don’t have to use the whole line of credit all at once, whereas with a cash-out refi, you get the whole loan as a lump sum all at once. Due to the nature of this line of credit, however, it’s more likely that the interest on a HELOC could fluctuate in correspondence with the market at a quicker rate, whereas the interest on a cash-out refi is more likely to be fixed for a longer period of time. This can often provide predictability in the near and long-term future.

Things to Consider when Contemplating a Cash-out Refi?

There are many things to take into account when considering a cash-out refi, such as:

Are you ready to deploy the cash you receive from this refinancing into a new investment, business, commercial space, renovation, etc?

How much of the equity in your property will you be able to access with a cash-out refi?

How much time is left on your current mortgage?

Has there been a change in interest rates that you can take advantage of while accessing your equity?

For those that are looking to buy a property, or want to make improvements on a current property to raise its value, a cash-out refi might make sense. However, there are many more aspects to keep in mind when examining if a cash-out refi is the right financial move, and a lot of these are situationally dependent. We advise you to speak with your financial consultants to see if a cash-out refi might be the right move for you.

To learn more, speak with our loan consultants today.

The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product.