Cash Out Refinance – What You Need To Know

What Is A Cash Out Refinance

“Re-financing an existing mortgage in excess of the balance is owed on the present mortgage, is called a cashout refinance.”

  • The present balance due is calculated after adding the settlement costs.
  • The reason why you can refinance for a greater amount than due is if the value of the house has increased, in other words there is built up equity in the home.
  • This extra cash can be used for various needs such as paying for the remodelling of the home, paying for education of a child, a wedding or any other important expense.

Things To Know About A Cash Out Refinance

They Carry a Higher Interest Rate

People who need a cash out refinance on their mortgages are usually the ones who are falling short of money and are therefore considered a high risk. Historically, they are also know to default on their payments more than regular borrowers. Therefore, the lenders charge a higher rate of interest to make good their investment as quickly as possible.

Try and get the best interest rate possible. Remember, that the equity in your home is being liquidated. Increased monthly payments dictate that a cash out refinance should ONLY be considered for important expenses.

Some people consider refinancing to invest the money further in a place that pays a higher return. This is a risky thing to do. Avoid this manoeuvre.

A New Mortgage On A Fully Paid Off Home Is Considered A Cash Out Mortgage

If a homeowner takes out the mortgage on a property that is already paid off it is considered to be a cash out mortgage. The lender again assumes that the home owner is in need of money hence the rates are higher.

Portfolio Lenders May Be Flexible

Lenders who originate loans to hold rather than to settle in the secondary market maybe more flexible in their definition of what constitutes a cash out refinance. They may not view a second mortgage as a cash out if the borrower has had a loan for some time or if the loan has been used to improve the property.

Property improvement might also exempt a loan on a property with no mortgage. Borrowers should be prepared to document the improvements however.

imporant facts about cash out refinance

Cash Out Refinance Has Been Subject To Frauds

It is something that has been used to commit fraud by predatory home loan lenders in the past. The borrowers are roped in by the prospect of a sizable amount of money and soon enough find themselves with mortgage payments that you could draw a sizable interest rate. Some people have taken out cash out refinance on property that was fully paid for only to realize that the payment to be made on the mortgage was beyond their means of paying.

Cash out refinance has been subject to malpractice which is what happened with homeowners who bought houses with assistance from Habitat for Humanity who then went on to refinance the zero interest loans provided to them under the program into high rate loans in order to generate cash.

Always Work With A Reliable Lender

Refinancing a mortgage is a complicated and tricky affair. You want to be dealing with a mortgage lender who has ethical practices and will not cheat you with hidden costs.

Working with a well-established lender makes the lending process much easier and avoids the pitfalls of dealing with a lender with questionable business ethics. The last thing that you need is to refinance your current mortgage with a lender who is going to offer you unfavorable terms on the sly such as balloon payments.

Do your research on the mortgage lenders before you decide to refinance your mortgage with them. Ask for a reference from your friends and family as they may be able to provide you with a first-hand experience and recommendation for a mortgage lender.

Keep A Watch On The Liquidation Account

You will have to watch out for how much of the equity in your home you want liquidated. You can have it all used up to provide you with the maximum extra money or you can choose to liquidate only as much as you need. You will have to ensure that the value of your house is appreciated properly and fully to ensure full benefit of the increased value.

Alternative to A Cash Out Refinance

There are other ways to get some extra cash out of the built up equity in your home. 

On of them is the home-equity line of credit. This way you do not have to undergo the complicated procedure and the cost of refinancing. 

Home equity loan is ideal when you only want to tap a small amount of the equity that is built up in your house. 

If you do not need the money all at once or if you don’t need the money for very long, you can see our section on home equity loans. You should remember at all points of that pulling cash out of your property may increase your refinance mortgage interest rate.

Effect Of Your Credit Rating 

A good credit rating is essential to getting a favourable deal from the mortgage lender. In order to deal with a bad credit situation and yet qualifying for a cash out refinance, you can do the following things. Get a cosigner who has a stellar credit standing. Unfortunately, you will be hard pressed to find people to do this for you. Only very close and caring family members are viable candidates.

Secondly, you can explore the market for sub-prime lenders. These kind specialise in making loans to people with poor credit ratings. They used to flourish till a few years back but you will them greatly lacking in numbers today, due to the mortgage crisis. 

We have written a post on Sub Prime Mortgage, and mentioned the few major and reliable players that are still have tolerable credit requirement. Read that post here.

Cash Out Refinance Through The FHA

If you have sufficient equity in your home then you can also refinance your existing mortgage with a cash out refinance through the FHA, provided you can meet the guidelines which are more strict as compared to are no cash refinance.

Here are the guidelines laid down by the FHA for cash out refinance. 

  1. All borrowers on the cash to refinance must be residents of the home. 
  2. The mortgage must have been current at all times. 
  3. The loan to value ratios cannot exceed 85% and may be lower if you own a home for less than one year. This amount includes the combined total of your refinance mortgage amount and any subordinate financing including the home equity loans and lines of credit. 
  4. You should not have been late on the mortgage insurance payment in the last 12 months. 
  5. Holders of a second lien on the mortgage must agree to remain subordinate to the FHA mortgage refinance.

In order to get the latest guidelines regarding a cash out refinance through the FHA contact your FHA approved mortgage lender.

Income Taxes Applicable On Refinancing A Home Loan

Usually there are no income tax repercussions of refinancing a mortgage. When you take out a cash out refinance on a mortgage you generate extra income. But since you are going to have to pay back you may not think of it as pure income. The IRS knows this and hence makes the money that you get during a cash out refinance as non-taxable. However, it is advisable to declare your refinance and its details during income tax filing so as to avoid any further contradictions and complications.

Forgiven Debt Is Taxable

Usually in the case of a cash out refinance you take out a new mortgage for an amount which is greater than the balance on your current mortgage and use the new loan to pay off your current lender. You get to keep the money that is left over after paying off the balance in full on your current mortgage.

However, if in certain cases you have settled with your current lender for an amount which is less than what you actually owe him on a mortgage then the IRS will consider this money that you saved as an income. For example if the remaining balance on your existing mortgage was $150,000 and you took out a cash out refinance for $180,000 you get to keep the additional $30,000 as non-taxable income after you have paid your existing lender is complete balance.

However, if you happen to settle with your current lender for an amount of $130,000 instead of $150,000, you have been forgiven a debt of $20,000 by your mortgage lender. This forgiven debt will be treated as a taxable income by the Internal Revenue Service.

Taxes Liable on Unpaid Debt

A situation like this can arise in certain cases of foreclosure of home loans. When a borrower is unable to pay off the mortgage the mortgage lender usually forecloses the loan and sells the house to recover the money that he lent.

In many cases the sale of the house does not result generate enough money to cover the losses of the mortgage lender. If a mortgage lender is not able to fully recover his loan from the sale of the house he can pursue the borrower to recover the remaining amount.

However, if the mortgage lender gives the borrower this amount then the IRS will consider this a given amount of debt to be an income and hence taxable.