You might be familiar with mortgage refinancing and recasting. There is a third financing type called the “cash out refinance.”
A “cash out refinance” allows you to get a cash amount as well as a new mortgage. Let’s say; you have credit card debt worth $55k. That’s a considerable amount, and the interest rate on the credit card debt can be insanely high. You need to do something about the situation.
One option is to do a “cash out refinance.” It has certain limitations and requirements but can be a suitable option for you.
You must have equity in the house. You need to have owned that home for at least one year and have paid the mortgage on time.
Another factor is the “loan to value.” What’s that?
Over time, property prices tend to go up. That means the value of your investment also increases every year. In this regards, the LTV (Loan-to-Value ratio) determines the value of the house compared to the outstanding mortgage. You can calculate the LTV using this formula:
LTV= Mortgage Amount/ Appraised Value
Let’s say, the value of the home is $270,000, and you have an outstanding mortgage worth $185,000. That means the loan-to-value ratio is 68.5%, which is good. A high LTV is considered risky for the lender as there are higher chances that the borrower will default on the loan. Most lenders approve a loan if your LTV is less than 80%.
You’ll pay a high-interest rate if you go for a “cash out refinance.” The reason being is that you’re borrowing more than the previous mortgage. Let’s continue our previous example.
Assume that your current mortgage is valued at $170,000 plus you have $55k in credit card debt. That means you need $225k to pay off your credit card debt and the existing mortgage. You’ll receive $55k in cash, and the rest will be transferred to the previous lender.
Mortgage refinancing is like taking a new loan. Like a new loan, it has its closing costs and associated charges. It might come as a surprise, but the closing costs and processing charges can make up thousands of dollars. Factor in these costs before refinancing your mortgage.
Paying these fees make sense when you are paying credit card debt or another high-interest debt. If you feel these costs are not justified, then a “cash out refinance” might not be a good option.
Another choice is the “Home Equity Loan or line of credit.” For example, if you need monthly payments, then go with a line of credit. You’ll be borrowing against your home equity, and you’ll pay back the amount later. Home equity loans have to be repaid through a balloon payment, and you can lose your home if you’re unable to pay back the borrowed amount. However, the good thing is that you are not acquiring an additional payment. You are also risking your home with a cash-out refinance.
You need to evaluate your choices before deciding. Discuss these options with your lender. Compare the closing costs, interest rate, payment terms, and the risk factor. A good rule of thumb is to never use the loan amount for buying a luxury item or a vacation. Don’t risk the house but these options are right solutions if you’re looking to pay off high-interest debt. For example, by converting credit card debt to the mortgage amount, you can deduct the mortgage interest rate from tax payments. Your credit score will go up because you have paid the credit card debt, and there are other benefits.