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Updated on Tuesday, January 22, 2019
If you’re looking to make a large purchase, such as a car or college tuition, and you have built up equity in your home, you might be interested in pursuing a cash-out refinance loan. With a cash-out refinance, you get a larger loan than the amount you owe on your home, and you get access to the surplus cash. Then you pay toward the entire sum monthly.
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“It’s an option if you have other expenses you need to meet,” said Tendayi Kapfidze, chief economist of LendingTree, which owns MagnifyMoney. “You refinance your mortgage and you get some money when you refinance. So if you owe $100,000, you take out $120,000, and you get $20,000 in cash.”
Another key aspect of a cash-out refinance is that, like other mortgage refinances, you can improve the terms of your loan. You can adjust your interest rate and loan term, and switch from an adjustable interest rate to a fixed rate if you want.
There are several types of cash-out refinance loans. Some are limited and just provide enough extra money to account for the closing costs on the refinance. Or they might cover just enough toward other specific purposes, like to buy out the interest of a co-owner in a divorce. There are also conventional cash-out loans and FHA-backed cash-out refinance loans. This article will cover FHA cash-out refinance loans.
What is an FHA cash-out refinance loan?
These loans are insured by the Federal Housing Administration (FHA). It’s easier to qualify for an FHA loan than a conventional cash-out refinance loan, and you may be able to borrow more money. But there are also certain disadvantages to FHA cash-out refinance loans. Read on to learn the pros and cons.
Advantages of an FHA cash-out refinance loan
- FHA cash-out loans have lower credit score requirements than conventional cash-out refinances. FHA cash-out loans require a minimum 500 credit score, although FHA-insured lenders often require a higher score. Conventional cash-out refinances require a credit score of at least 620.
- FHA cash-out loans have more flexible loan-to-value (LTV) guidelines. Your LTV is the amount you’re borrowing divided by the value of your home. FHA-backed cash-out loans allow you to get a loan of up to 85% of your home’s current value (which you’ll obtain through a new appraisal). With a conventional cash-out loan, you can only get a loan of up to 80% of the value of your home.
- You don’t need to already have an FHA mortgage loan to get an FHA cash-out refinance loan.
Disadvantages of an FHA cash-out refinance loan
- There are loan limits. The Department of Housing and Urban Development (HUD) sets the limits at 115% of the median home price in your area. You can enter your information on the HUD website to find out the limits where you live.
- The FHA requires you to pay mortgage insurance premiums (MIP) — which you pay both upfront (at 1.75% of the loan amount) and monthly (adding up to 0.80% each year). MIP protects the lender in case you default on your mortgage. This is not required with conventional cash-out refinance loans and adds costs to the FHA cash-out refinance.
- You might want a co-borrower who does not live in the home if their credit and income can help you secure the mortgage. For FHA cash-out refis, this is not allowed.
- You can’t have made any late mortgage payments in the last year.
Guidelines and eligibility
You’ll need to have the following to qualify for an FHA cash-out refi:
- Official minimum credit score of 500, although individual lenders may have different requirements.
- At least 15% equity in your home.
- Debt-to-income ratio — your total recurring monthly debt divided by your gross monthly income — of 43% or less, usually. If you have a high credit score and/or a significant amount of equity in the home, you can have a debt-to-income ratio of up to 50%.
- Maximum LTV of 85%.
- On-time mortgage payments for the past 12 months.
- Much of the same documentation as when you obtained your initial mortgage, including pay stubs, bank statements, W-2 forms and proof of on-time mortgage payments.
- Residency in the home. In other words, you must live in the home to get an FHA cash-out refinance loan. By comparison, conventional cash-out loans can be used on second homes.
How to use a cash-out refinance
There are lots of good ways to use your cash-out refinance. But remember that your home equity is being used for collateral, so your house is at risk. For that reason, it’s better not to use this type of loan for a vacation or luxury purchase, but rather for important investments that will save or earn you money.
Potential uses include:
- Paying for a home improvement project
- Making a larger purchase, like a car or home furnishings
- Consolidating debt or paying off personal debt, such as from high-interest credit cards
- Paying off an auto loan
- Paying for higher education
Alternative borrowing options
There are other ways to take out a loan for large purchases or bills. Here are some options:
- Conventional cash-out refinance. These loans require a better credit score and offer a lower loan-to-value amount. But they do not require mortgage insurance premiums. Otherwise, these loans are very similar to FHA cash-out refinances.
- Home equity loan. A home equity loan is a lump-sum payment at a fixed interest rate, based on the amount of equity you have in your home. If you are pursuing a home-improvement project, this type of loan could include tax breaks.
- Home equity line of credit (HELOC). You can also access the equity in your home with a HELOC. You get approved for a specific line of credit and can use however much of it you need. A HELOC has a variable interest rate. As with a credit card, you can borrow against the line of credit, pay it back, and borrow against it again. HELOCs may also be eligible for a tax break.
- Personal loan. A personal loan allows you to access a lump-sum payment. However, unlike the other options on this list, it does not require collateral. You won’t have to have equity in your home to obtain a personal loan, but interest rates can be high.
An FHA cash-out refinance loan might be right for you if you have a large purchase to make or require a significant amount of cash to make home repairs or start a business. Weigh your decision carefully. You might want to first talk to a qualified financial professional about your options, because your needs might be better met with a conventional cash-out refinance or even a home equity loan or a personal loan.
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