A cash-out refinance is when you refinance your mortgage for more than the size of your existing mortgage. The difference between your new mortgage amount and your old mortgage amount can then be “cashed out” in cash. In other words, a cash-out refinance lets you borrow money using your home equity through your mortgage. Cash-out refinances are sometimes referred to as equity take-out.
How a cash-out refinance works is that you are replacing your existing mortgage with a larger mortgage. After paying off your existing mortgage, you will have money left over that you can then use. The amount that you can borrow with a cash-out refinance will depend on how much home equity you have.
Your home equity is based on the value of your home and the size of your mortgage. You will need to get a home appraisal since your lender will only consider the appraised value of your home. The difference between your home’s value and any debt tied to your home, such as your mortgage, is the equity that you have in the home. That’s because you will need to pay off this debt when you sell your home, so the amount remaining is your equity. You can use your home equity to borrow money by using your home as collateral. This lets you access your home equity without needing to sell your home. Otherwise, you will only be able to get access to your home equity when your home is sold.
Over time, as you continue to make mortgage payments, your mortgage balance will decrease. This increases your home equity if your home value stays the same. However, your home value also affects your home equity. If the value of your home increases, then your home equity also increases. That’s because if you were to sell today, you will be able to get a higher selling price while the mortgage debt tied to the home stays the same. If home values decrease, then your home equity will also decrease. It’s possible for your home equity to decrease even when you are making regular mortgage payments during instances where your home value decreases more than your mortgage principal payments.
With a cash-out refinance, you can borrow up to 80% of the value of your home. This includes both the mortgage balance and the amount that you want to cash out and is also referred to as your loan-to-value (LTV) ratio. The higher your loan compared to the value of your home, the higher the LTV ratio.
The difference between a cash-out refinance and a refinance is the amount that you are borrowing. With a regular refinance, your new mortgage will be for the same amount as your existing mortgage. The only change might be your mortgage rate. If your new mortgage rate is lower, you will be saving money through lower mortgage interest payments. With a cash-out refinance, you are increasing your mortgage balance amount, in addition to other possible changes such as your mortgage rate. Since you are borrowing more money, your mortgage payments might also be larger.
The maximum LTV ratio for a cash-out refinance is 80%. Depending on your credit and income, you might not be able to qualify for a 80% LTV. If you have bad credit, the maximum allowed LTV by your lender might be lower.
For example, let’s say that your home is valued at $500,000, and you currently have a $300,000 mortgage. This means that your current LTV is 60% ($300,000 divided by $500,000). With a maximum LTV of 80%, you can borrow up to an additional 20% of your home’s value, or $100,000. You can refinance your mortgage for $400,000, pay off your existing mortgage of $300,000, and withdraw $100,000 in cash.
To calculate how much you can borrow, use our mortgage refinance calculator to see how much home equity you can access and how a change in mortgage rates can affect your mortgage payments.
With a cash-out refinance, you can borrow a large amount of money at a low interest rate, and it will require lower monthly payments compared to other methods of borrowing. Here are the pros of a cash-out refinance:
Borrow More Money
Cash-out refinancing is done so that borrowers can borrow more money. However, cash-out refinances are chosen specifically so that borrowers can borrow a large amount of money all at once. This is in comparison to other options that might have lower limits, such as personal loans or lines of credit.
Borrow At a Low Interest Rate
Since you are borrowing money as a secured loan through your home, you will be paying a low interest rate. Unsecured loans, such as personal loans, will have much higher interest rates.
Borrow With Smaller Required Payments
Mortgages are amortized over a period that can be 25 years or even longer. This means that your mortgage payments are spread out over a very long period of time. If you were to borrow with a personal loan, for example, you would have to repay the loan in a shorter period of time, which will require higher loan payments.
The pros are all based on borrowing more money, but borrowing more money can be a con in itself. Borrowing more means that you will be paying more. Here are the cons of a cash-out refinance:
Borrow More Money
Borrowing more money can be both a pro and a con. If you’re not financially responsible, or you’re borrowing money for purposes that won’t add value or save you money, then the ability to borrow more money might not be such a good thing.
Higher Interest Costs
The money that you’re borrowing isn’t free, and it will come with interest costs. Unless you’re able to refinance at a significantly lower mortgage rate, it’s likely that your monthly interest payments will increase. You’ll be paying more interest than you otherwise would.
Borrowing more money with your home as collateral means that you are putting your home more at risk than before if you’re not able to keep up with mortgage payments. This is especially true since your cash-out mortgage payments will now be higher. If you can’t keep up with your payments, you might face foreclosure or power of sale.
Since you still need to pay interest on the additional amount that you borrow, you should try to use the money wisely. This can include things that can save you money or can make you more money. Some uses for a cash-out refinance include:
Paying Off Other Debt
Consolidating your debt can save you lots of money, especially if it’s high-interest debt such as credit cards. In fact, debt consolidation was the top reason that Canadians refinanced their mortgage. You can pay off credit cards, personal loans, lines of credit, car loans, and student loans with money from a refinance.
Home Improvements and Renovations
Home improvements was the second most popular use of mortgage refinances. Home renovations can help increase the value of your home, which means that you are putting your home equity to work to generate even more home equity. Home renovation projects can include a kitchen remodel, upgrading your landscaping, and replacing your appliances.
You can save money by making energy-efficient improvements that can reduce your heating and water bills, such as adding insulation, upgrading to energy-efficient windows and doors, replacing light bulbs, and getting a high-efficiency heating and cooling system. You may even invest in a solar electric system. If you have a CMHC-insured mortgage, making these upgrades can even save you money through CMHC insurance premium refunds.
You can use money from your mortgage refinance to invest. This might be starting a new business, investing your money in stocks, or even purchasing another property the basis of the BRRRR method. Borrowing money to invest can be risky, especially if your returns aren’t guaranteed. That’s because you’re still paying interest no matter your return, and if you have negative returns, then you will need to find a way to eventually pay the losses back.
Using your home equity to invest can be a possibility for homeowners that want to take on risk for potentially high returns. For homeowners that want more exposure to the real estate market but don’t want to directly manage another property, some real estate investment ideas include purchasing real estate investment trusts, ETFs, or mutual funds.
The Bank of Canada found that of the money borrowed from home equity, 28% of it went towards debt consolidation, 25% towards home renovations, 25% towards consumption, and 22% towards investments.
Use of Home Equity Dollars
What shouldn’t a cash-out refinance be used for?
Money from a refinance is still borrowed and will eventually need to be paid back. That’s why it is better to direct it towards productive uses, such as to save money or make money. Refinancing can also be used to pay for things that you really need, like using it to buy a new car. Things that a refinance might not be a good idea for are non-essential consumption and spending. This might include vacations or jewelry. If you couldn’t otherwise afford it without a refinance, it might not be a good idea to spend a cash-out refinance on it.
You can still refinance your mortgage even if you have bad credit. However, you may be approved for a smaller amount than you would like, and your interest rate might be higher. Since you are replacing your old mortgage with a new mortgage, you will still need to pass your lender’s minimum credit score requirements for a mortgage. You will also need to pass the mortgage stress test when refinancing your mortgage.
Having a bad credit score can make it difficult to be approved for a cash-out refinance with a traditional bank. You can choose to refinance with a monoline lender or private mortgage lender, but they might charge significant fees and interest rates. If you know that you want to refinance your mortgage in the future, then you should try to improve your credit as soon as possible.
Do I need to report the money I receive from a cash-out refinance as income? The simple answer is no. Your cash-out refinance money is debt, not income, since you will eventually have to pay it back. You won’t need to report your cash-out refinance as income when filing your income taxes.
Are cash-out refinances tax deductible? In Canada, your mortgage interest isn’t tax deductible, even for cash-out refinances. That’s because you can only deduct interest at tax time if the loan was used for investments. One way around this is called the Smith Maneuver, which is a way for you to turn your mortgage interest into a tax-deductible expense.
A cash-out refinance isn’t the only way that you can access your home equity. Refinancing your home can come with large mortgage penalties if you refinance before the end of your term. You will also be forced to accept the market’s current mortgage rates, which might not be ideal if you’re already locked into a lower rate. Since you’re borrowing an additional amount as a one-time lump-sum payment, a refinance also isn’t a flexible way to borrow money. You will need to pay mortgage interest on the entire amount borrowed, even if you don’t need it all right away. Here are alternatives to cash-out refinancing:
Home Equity Line of Credit (HELOC)
A home equity line of credit lets you access your home equity just like a credit card. You have a credit limit, up to 80% of your home’s value, that you can freely spend and pay back at any time. This makes a HELOC a much more flexible alternative to a mortgage refinance. However, HELOC rates are higher than refinancing rates. HELOC rates are also usually a variable interest rate based on the prime rate. On the other hand, you can choose to get a fixed interest rate for a mortgage refinance.
Home Equity Loan
A home equity loan is a separate loan that you can take on top of your existing mortgage. You can also borrow up to 80% of your home’s value after your existing mortgage, and taking a home equity loan won’t affect your mortgage. This means that you won’t need to pay any mortgage penalties since your existing mortgage stays the same. Home equity loans will have higher interest rates than a mortgage refinance.
A reverse mortgage is a unique mortgage that lets you receive payments, instead of you paying the lender. You can access your home equity through lump-sum payments or through regularly scheduled payments. For example, you can get a reverse mortgage that pays you $2,000 a month for a 5-year term. This sets up a steady stream of income that can be useful for retirees or those needing to supplement their income. Reverse mortgages are only available in Canada for those over the age of 55.