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Thinking about a cash-out refinance to pay for home improvements, college tuition, or consolidate high-interest, non-mortgage debt? Depending on your circumstances, they can be an ideal way to cover major expenses or build savings at a low interest rate. But, as with any mortgage, it’s important to plan ahead to help guarantee you receive the best loan terms and rates possible. To help ensure you get the most out of yours, here are some cash-out refinance mistakes to avoid.
Mistake #1: Cashing out more equity than you need
Home equity equals the appraised value of your home minus any debts (aka liens) against your home, such as your mortgage. As you watch it rise, you may be excited to cash out as much as possible, but it’s wise to temper your goals because cash-out refinances result in a higher mortgage balance. As an example, if you owe $200,000 on your current mortgage and cash out $50,000, your new mortgage would be for $250,000. That new mortgage will likely result in a higher payment that could stretch your budget and put you in a financial bind if left unchecked. A mortgage payment calculator can help you estimate what you can comfortably afford.
A second risk of cashing out too much equity is that your mortgage could go underwater. That’s when your mortgage balance is more than your home is worth. Given that, if you refinance your home to $300,000 but its value drops to $280,000 due to market changes, you may not be able to sell your home or borrow more equity when you want to.
Mr. Cooper customers: Learn more about your home’s estimated value & equity here.
Mistake #2: Not knowing you may need to leave some equity in your home
Cash-out refinances typically limit how much home equity a homeowner can take out. Many of them require homeowners to leave 20% equity in their homes. That said, if you don’t have more than 20% equity on a refinance that requires it, you’ll have nothing to cash out. On a $300,000 home, that would translate to needing at least $60,000 in equity ($300,000 x 0.2 = $60,000) before accessing any in cash.
Standards can vary by lenders and loan types, however. VA loans, for instance, may let you to leave 10% equity or less in your home depending on your lender. But, when your equity dips below 20% you’ll likely have to pay the added cost of private mortgage insurance, which we’ll discuss more below. Avoid this cash-out mistake by planning around possible scenarios.
Mistake #3: Making big credit purchases
An important cash-out refinance mistake to avoid is opening new credit accounts or making large purchases on credit while also trying to qualify for a refinance. Opening new credit accounts can lower your credit score because it can lower your credit age. This accounts for 10% of your overall FICO® score. Making purchases on credit can also be a drag on your credit score and affect your debt-to-income (DTI) ratio (see below). Talk to a mortgage professional about what could potentially impact your score ahead of applying and stick to the plan through your loan’s closing.
Mistake #4: Having too much debt
Debt is a major factor that lenders consider during the loan approval process. To gauge it, they calculate a borrower’s DTI ratio. You can estimate yours by dividing your total monthly payments by your gross monthly income. Example: You have $5,000 in monthly income and your debt payments total $1,000 a month. Dividing $1,000 by $5,000 gives you a DTI of 20% ($1,000 ÷ $5,000 = 0.20 or 20%). Maximum DTI for mortgages varies by lender and loan type, but generally ranges between 40 and 50%.
Mistake #5: Failing to weigh your options
It may be convenient to go with the first lender who prequalifies or pre-approves you for a cash-out refinance, but it may not be the best deal. Shopping around with multiple mortgage companies may result in financial savings, better loan terms, or a bigger loan. Consider that securing a 30-year fixed rate mortgage at 3.5% APR instead of 4.0% APR on a $300,000 loan might save you more than $11,000 in the first 10 years of the mortgage alone.
Mistake #6: Not considering all the costs
Cash-out refinances will leave you with more money in hand, but it will come at a cost. As you know from your current mortgage, home loans involve closing costs and fees. Closing costs such as appraisal fees and loan origination fees can add 2–5% to a home loan, or $6,000–$15,000 on a $300,000 loan. Depending on your lender, you may be able to wrap costs into your loan, but it will likely take longer to pay off your loan and you’ll pay more interest. Avoid this mistake of paying more than you intended by budgeting for these expenses and factoring in their costs over time.
Private mortgage insurance may also be a concern if you refinance and leave less than 20% equity in your home. PMI premiums typically add 0.5–1% or more to a mortgage balance annually.
Mistake #7: Failing to lock your rate
Finally, once you’ve found a competitive cash-out refinance loan, don’t let your rate fall through. Many lenders will lock a rate for 30 to 60 days, so be clear on your lender’s timetable to guarantee the best deal for you.
The good news is that with the right planning, a cash-out refinance may be far from a mistake. By using your home equity wisely, you may save money over time compared to other financing options. To learn more, check out our refinancing guide or contact us today.
*A cash‐out refinance increases your mortgage debt and reduces the equity you may have in your home. Your monthly mortgage payments may be higher. A debt consolidation refinance increases your mortgage debt, reduces equity, and extends the term on shorter‐term debt and secures such debts with your home. The relative benefits you receive from debt consolidation will vary depending on your individual circumstances. You should consider that a debt consolidation loan may increase the total number of monthly payments and the total amount paid over the term of the loan. To enjoy the benefits of a debt consolidation loan, you should not carry new credit card or high interest rate debt.
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