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You’re eager to start that kitchen remodel, bathroom redo, attic expansion, landscaping reboot, or other fix-it project.
Problem is, you don’t have enough saved so you’ll need to borrow money to fund the endeavor. But what financing vehicle should you choose?
Don’t close the door on a cash-out refinance of your existing mortgage loan. Even though mortgage interest rates are likely higher today than they were when you first took out your mortgage loan, a cash-out refi can be a good option under the right circumstances.
How a Cash-Out Refi Works
With a cash-out refinance, you replace your existing mortgage loan with a brand-new conventional, FHA, or VA home loan that has a higher balance. The difference between those balances is cashed out in a lump sum when the loan closes, and these dollars can be used for renovations.
These cashed-out funds represent a portion of your home’s accrued equity, which is the difference between your property’s current value and the outstanding mortgage balance. Many lenders require that you not exceed a loan-to-value (LTV) ratio of 80% on a cash-out refi.
In other words, you typically need to maintain 20% equity in your home when you pursue a cash-out refinance. (Note that you’ll be required to pay for private mortgage insurance if your LTV exceeds 80%.)
“A good candidate for a cash-out refinance is anyone who probably has more than 25% equity in their home,” says Eric Jeanette, president of Dream Home Financing. “This leaves enough room to cash out equity, cover closing costs, and still come in below the 80% LTV mark to avoid paying PMI, although PMI is still required if you choose a cash-out FHA refinance loan – no matter the LTV.”
When you refinance, you reset your mortgage to a new term—typically 10 to 30 years—at a fixed or adjustable interest rate. As you did with with your existing mortgage loan, you’ll need to complete a loan application, qualify by providing documentation of your income, assets, and debts, get your home appraised, and be approved by the lender based on factors like your credit score and debt-to-income ratio.
What are the Benefits of a Cash-Out Refi?
“Many homeowners select a cash-out refinance to pay for home improvements because the interest rate is typically much less than they would be saddled with if they paid for home improvements via a credit card or personal loan,” Jeanette continues.
Consider that the average fixed interest rate at the time of this writing for a conventional loan cash-out refi was 6.97%, versus about 10.82% for a personal loan and 20.22% (variable rate) for most credit cards, per Bankrate.
“Cash-out refinance loans are also attractive due to their tax advantages,” explains personal finance expert Andrew Boyd, a financial advisor with Finty. He notes that you may be able to deduct some of the interest paid on a cash-out refi if you itemize your deductions, although the full amount is only deductible if you use the money for capital home improvements (click here for the specific IRS rules; consult a tax professional for full details).
» MORE: See today’s refinance rates
Higher Refinance Rates Don’t Have to be a Dealbreaker
The fixed interest rate on a cash-out refi loan today will likely be higher than your current rate. But that doesn’t mean you should rule out a cash-out refinance entirely.
“You could do the cash-out refi, rehab the home, and then sell it – hopefully for a sizeable profit that more than pays for the costs of the refinance. In this case, the higher interest rate you will pay is less impactful because your home will be sold in the near future,” says Jeanette.
Or, consider a cash-out refinance loan with an adjustable interest rate (ARM). With an ARM, you lock in a fixed interest rate for a set period, such as the first three years (3/1 ARM) or five years (5/1 ARM), after which time the rate can go up or down depending on rate market conditions at the time.
Current average fixed rates for a 5/1 ARM are 5.71%, according to Bankrate.
“An adjustable-rate cash-out refinance can be a good way around current interest rates, since your rate will likely go down when the Federal Reserve backs off its inflation control measures,” says Martin Orefice, founder of Rent To Own Labs. “Then, when the ARM rate rises after your fixed-rate period ends, you could try to refinance to a lower fixed-rate mortgage, assuming the fixed rate is less.”
Cash-Out Refinance Alternatives
Alternatives to a cash-out refi include a home equity loan or home equity line of credit (HELOC), which each has its pros and cons. The average fixed rates right now for home equity loans are 8.08% versus 7.99% for HELOCs.
Instead, you could opt for an FHA 203(k) rehab loan, which can be used to refinance your home and fund renovation-related expenses, although lender requirements and eligible home improvements can be a bit more strict than for other financing choices.
Regardless of the financing option, “carefully consider the closing costs, potential changes to your mortgage terms, and the possibility of increased monthly payments before committing to a new loan or line of credit. Evaluating the return on investment from the home improvement project is also essential,” advises Boyd.