Mortgage Basics #Loan Types

Cash-Out Refinance in Canada


Key Takeaways

  • A cash-out refinance involves breaking your mortgage early, borrowing against the equity in your home, and taking out a specific amount of cash.
  • You generally need to have a minimum of 20% equity in your home to qualify for cash-out refinancing
  • Cash-out refinances involve taking out a larger loan than you currently owe on your remaining mortgage balance, and keeping the difference in cash.
  • There are a number of pros and cons to this style of refinance, as well as a number of alternative lending solutions.

What Is a Cash-Out Refinance?

In Canada, refinancing is the process of breaking your mortgage early, and paying off the balance in full using another mortgage loan. In a cash-out refinance, you borrow more than you owe on your remaining mortgage, and use the equity in your home as collateral for the higher loan.  Typically, people use refinancing to get a lower rate of interest on their mortgage, which can help reduce their monthly payments. However, another common reason people refinance is to access the equity in their home. 

Tip: As you pay off your mortgage, you build what is known as equity. In simple terms, equity is the amount of your home that you actually own, as opposed to value that is still covered by a mortgage loan. 

A cash-out refinance, then, involves the same process as a normal refinance, except you would apply for a higher loan than the amount of mortgage you still owe, and take out the difference as cash. Generally, people use cash-out refinancing to access cash for things like home improvements, to help pay for tuition, a vehicle, or other investments. The main difference between a regular refinance, and a cash-out refinance, is that in the former, you are simply changing your mortgage for the same amount, whereas in the latter, you are changing your mortgage for a higher amount, paying off the old mortgage amount, and keeping what’s left over as liquid cash.

Pros and Cons of a Cash-Out Refinancing

Cash-out refinancing can be a useful way to access cash by tapping into the value of your home. However, there’s a few things to consider when opting for a cash-out refinance.

Pros

  • Borrow money against the value of your home. This is the primary benefit of a cash-out refinance. Borrowing money against the value of your home frees up cash for things like home improvements, investments, or other costs.
  • Larger loan amounts. A cash-out refinance can be a good way to borrow more money with a lower interest rate than, for example, a personal loan or line of credit. Additionally, since you’re borrowing against your home, lenders will often allow you to borrow more. Typically, cash-out refinances will let you borrow up to 80% of the value of your home (since you must have 20% equity to qualify).
  • Low interest rates. Depending on your lender, mortgage rates are generally some of the lowest interest rate loans available, so refinancing into a higher mortgage and taking out the difference as cash can be one of the most affordable ways to borrow a large sum of money in one go.
  • Longer repayment terms. Since refinancing involves getting a new mortgage, mortgage loans typically have much longer repayment periods, since the full amount of a mortgage is amortized over a longer period of time. However, for some this can be considered a downside. Since you’re borrowing more, your mortgage may take longer to pay off overall.
  • Cash-out refinance is not taxable as income. Since the money you get from a cash out refinance is technically debt, you will not need to report it as income when filing your income taxes. While this isn’t necessarily a benefit, as you’ll have to pay back the debt eventually, it’s useful to know that any money you take out of your home in a refinance of this kind will not have to be taxed as income.

Cons

  • Longer repayment terms. As mentioned, refinancing involves taking out a new mortgage. When you increase the amount you’re borrowing, you may find yourself paying off your mortgage over a longer period of time, or with higher monthly repayments. Ultimately, how you structure the additional debt is up to you, and it’s worth striking a balance between the amount of money you’re able to repay each month, and the length of time you want to be paying back your loan.
  • Higher interest costs. The more money you borrow in a mortgage, the more you’ll have to pay over the subsequent mortgage terms as interest, since there is a higher amount of money that interest is being applied to in a larger loan.
  • Risk of defaulting on your new mortgage loan. Make sure you can keep up with your new repayment schedule if you borrow more money than your previous mortgage. Use or mortgage refinance calculator to get a sense for what your payments would look like for a cash-out or regular refinance.
  • Closing costs. As with any other mortgage, you’ll have a number of costs associated with a refinance, since it is a new mortgage. Breaking your mortgage early is required for a refinance (as opposed to a simple renewal), and this will usually mean you’ll have to pay a prepayment penalty. You’ll also have to pay a mortgage discharge fee if you change lenders, a registration fee, home appraisal costs, and other legal fees. Obviously, these can all add up.

How Does a Cash-Out Refinance Work?

A cash-out refinance involves the same process as a regular refinance, except now, instead of borrowing the amount you still owe on your mortgage (e.g. $300,000), you would borrow more money, using the equity you have in your home as collateral. The additional money you borrow against the value of your home (e.g $50,000), would be combined with your outstanding mortgage amount and lent to you as one larger loan ($350,000). You would then be able to pay off your old mortgage, and keep the difference as cash. Ultimately, you will make payments on the whole amount you borrow in a refinance, at the same rate of interest. 

Your equity percentage does not go down when you refinance (assuming the market value of your home doesn’t change for other reasons). Instead, you are using the equity you’ve built as security (collateral) for the new, additional loan amount. Keep in mind that in a cash-out refinance, you can only borrow up to 80% of the value of your home, and you must have at least 20% equity in your property in order to be approved. On top of this, you will need to ensure you have solid credit, a manageable debt-to-income ratio, and proven consistent income to qualify for a higher loan amount.

Example of a Cash-Out Refinance

The maximum loan-to-value (LTV) ratio of a cash out refinance is generally 80%. What does this mean? As we outlined before, it means you need to have at least 20% equity in your home – i.e. any outstanding mortgage loan you are still paying off for your home may not be more than 80% in total of your home’s appraised market value.

By way of example, if your home’s market value is $500,000, and you’ve paid off 50% of that and turned it into equity, you would have $250,000 equity and still owe $250,000. If you were to opt for a cash-out refinance, you can borrow up to 80% of your home’s total value, minus the outstanding amount. 80% of $500,000 is $400,000, subtracting $250,000 still owed, leaves you with an additional $150,000 you will be able to borrow, on top of what you already owe. Your new mortgage loan would therefore be $400,000, but you would have $150,000 left remaining as liquid cash. To see how much you can borrow and what your monthly repayments would look like with a cash-out refinance, check out our refinance calculator.

When Does a Cash-Out Refinance Make Sense?

There are a number of scenarios in which a cash-out refinance can make sense. The main reasons people in Canada choose to take equity out of their home by refinancing with a larger mortgage are as follows:

  • To consolidate debts. Mortgage interest rates are generally lower than consumer debt products, like credit cards, personal loans, or lines of credit. For that reasons, paying off consumer debts with the cash you take out of your home in a cash-out refinance can help you lower the amount of money you will pay in interest, reduce the number of creditors you have to one lender, and help you get your finances back on track.
  • To pay for renovations and home improvements. Taking cash out of your home for home improvements can be a solid investment, since it can ultimately improve your home’s market value, thereby increasing your equity even further.
  • To pay for tuition. Cash-out refinancing can be used for a number of investments, whether personal, professional, or in other capital assets. Among these, paying to learn new skills or explore a new area of learning are common reasons why some Canadians take cash out of their home.
  • To start a business or inject funding into an existing business. Given the lower interest rates on a mortgage compared to other personal and business loans, cash out refinancing can be an effective way to free up funding for a small business, or to provide funds to start a new business.
  • To fund other investments. A cash-out refinance could be a great way to access cash quickly for a downpayment on another property, at a relatively low interest rate compared to other solutions, like home equity loans or personal loans.

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Cash-Out Refinancing Alternatives

A cash-out refinance may not be the best way to borrow against your homes equity, and there are alternatives available. One of the drawbacks of a cash-out refinance, besides the closing and prepayment costs associated with breaking a mortgage term early, is the fact that you will be paying interest on the entire amount borrowed from the moment you take out the new mortgage loan, even if you’re not using the whole amount right away. Here are some alternatives to consider when looking into cash-out refinancing.

Home Equity Loan

A home equity loan is similar to a cash-out refinance, in that you would take it out on top of your existing mortgage amount, and secure the new additional loan amount against the equity in your home. Like a cash-out refinance, a home equity loan allows you to borrow up to 80% of the value of your home after subtracting your existing mortgage balance. With a home equity loan, you don’t need to break your mortgage early, so you won’t have to pay any prepayment penalties. Conversely, however, you’ll also probably have to pay a higher rate of interest with a home equity loan than with a cash-out refinance.

Home Equity Line of Credit (HELOC)

A HELOC is a popular choice for a lot of homeowners looking to access cash in a flexible, relatively low interest way. HELOCs let you access your home equity, to a maximum of 80% of the value of your home (after subtracting your outstanding mortgage balance.) Unlike a lump-sum loan, HELOCs are a revolving line of credit, meaning you would only pay interest on what you spend. HELOC interest rates are generally more favorable than home equity loans, but are usually comparatively higher than refinancing.

Reverse Mortgage

A reverse mortgage lets you receive payments, instead of paying your lender. As with a regular mortgage, reverse mortgages accrue interest. The interest on a reverse mortgage, as well as the principal paid out to the homeowner must only be repaid once a property is sold or after the homeowner passes away or moves into long-term care. Reverse mortgages are only available in Canada and for those over the age of 55.


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