There may be situations in life when unexpected expenses come your way. When it happens, refinancing your home loans and taking cash out may be a smart way to raise the funds you need. Known as a cash-out home refinance, it helps you avail loans at a lower interest rate compared to personal loans or credit card debts. However, a cash-out refinance may not always be the right choice.
Keep on reading to find out what a cash-out refinance is, how to avail one, how it works, and above all, whether it's the right choice for your situation.
What is refinancing?
While it may sound complicated, refinancing is a simple procedure and is quite easy to understand. The basic idea is that you transfer an existing home loan from one provider to another. It's replacing an ongoing home mortgage with a new one. Generally, people refinance to avail better interest rates on their home loan, to change the tenure of the loan, or to pay off the loan sooner than expected.
How is cash-out refinancing different from regular refinancing?
Cash-out refinancing is a process of refinancing your home loan, while also borrowing additional money at the same time. The new lender takes over your existing home loan, while also issuing you a cheque for the surplus funds you have borrowed. Going forward, you repay the current home loan as well as the new loan borrowed to the new lender, in the form of monthly EMIs.
For example, let’s say that you still owe Rs. 20 lakhs on your home loan to your lender. You now need an additional Rs. 5 lakhs to cover the cost of some remodelling work in your home. By opting for a cash-out refinance, you can start a new home loan worth Rs. 25 lakhs. The new lender will pay off the outstanding Rs. 20 lakhs to your old lender and issue you a cheque of Rs. 5 lakhs to cover the remodelling costs. You continue to pay EMIs to the new lender till you have paid off the entire Rs. 25 lakhs along with the interest you owe.
How to use the money you receive from a cash-out refinance?
There are no restrictions on how you spend the money you receive from a cash-out refinance. You can use it for home remodelling, home repairs, to pay for your child’s education, to meet emergency medical expenses, to start a business or to pay off any other debts you owe.
Some common reasons why people refinance their home and take out money include:
Home Improvements – Very often, borrowers take money out by refinancing a home loan to make various repairs and improvements around their home. Regular maintenance and updates to your home increase the market value of your home, thereby making it easy to recover your costs when you sell your home.
Educational Expenses – Another common reason why people take money out of their home refinance is to pay for the higher education costs of their children. Since education is seen as a worthwhile investment, this move is recommended even by financial experts.
To Fund Business Ventures – This is one of the riskier moves, as there is no guarantee that your business will provide you with successful returns. Before you opt for a cash-out refinance, it's highly recommended that you work out the ways you will repay the loan if your business fails.
Debt Consolidation – You can use the money received from a cash-out refinance to close all your high-interest debts like credit card outstanding and personal loans.
While these are some of the common reasons why people take money out of a home-refinance, they are not always the smarter choice. There are other loans available to meet these needs. Before we explore the alternatives to cash-out refinance, let's take a look at the pros and cons of a cash-out refinancing.
Pros and Cons of Cash-Out Refinancing
Cash-out refinancing is an appealing option. After all, what’s there not to like about switching your home loan to a lower-interest-rate while also receiving some cash in the process? However, just like all other loans, cash-out refinancing has both pros and cons. Make sure that you evaluate both the benefits and drawbacks of this scheme before signing on the dotted line.
Benefits of Cash-Out Refinancing
You can avail large sums of money. Since houses are big-ticket items that are worth tens of lakhs of rupees or even more, you can opt for cash-out refinancing to borrow large sums of money.
Low-interest rates. When compared to other unsecured loans like personal loans or credit card debts, cash-out refinancing helps you borrow at lower interest rates.
Long repayment tenure. By replacing your existing home loan with a new loan, you can extend the tenure to 20 or 30 years. This means your monthly EMIs reduce. However, the total interest you repay increases. So, be aware of the interest rate implications before stretching the tenure.
Drawbacks of Cash-Out Refinancing
Risk of foreclosure – This is the biggest danger of taking money out while refinancing your home. If you’re unable to repay the loan, you stand the risk of losing your home itself.
Increase in loan burden – When you take money out from home refinancing, you’re essentially restarting the clock on your home loan burden. This increases the interest costs of the loan, while also extending the tenure. Hence, you will be stuck with your housing debt for a long time to come.
Drop-in your credit score. When you refinance your home mortgage, you can notice a drop in your credit score. It takes a couple of years to reset it to the normal levels.
Pre-closure penalties. You have to pay the closing costs to your old lender before you can switch your loan to the new lender.
Alternative Ways to Raise money instead of Cash-Out Home Refinance
Taking money out while refinancing your home is a huge step. If you’re unable to repay the loan on time, you risk losing your home. So, if you prefer other less risky options, here are other ways to raise money to meet your cash needs:
Personal Loans – An easy to avail loan, personal loans are unsecured loans that can help you meet all your cash needs. Banks, NBFCs and several digital lenders offer personal loans at attractive interest rates. The best part – personal loans are unsecured, meaning you do not have to submit any collateral or guarantee.
Education Loans – These are specialised loans offered to meet the education costs of students. They come with attractive interest rates and flexible repayment terms.
Small Business Loans – As the name implies, they are specially designed to help small business owners meet their various business needs. You can use this loan to expand and develop your business.
How to get approved for cash-out refinance?
The eligibility criteria vary from one lender to another. Generally, to qualify for cash-out refinance, you need to have a good credit score, stable income, and excellent credit repayment history. Make sure to shop around and evaluate the deal offered by different lenders to find the best one that comes with an attractive interest rate.
The Bottom Line: Proceed with Caution
Before you take money out using a home-refinance, make sure to evaluate all the consequences of this step. It's highly recommended that you search for alternative ways to raise cash without putting your home on the line. And, if nothing else works out, make sure to guarantee loan repayment before you decide to take money out with a home refinance.