Cash-out refinance: How does it work?
Updated 2:36 PM EDT, Wed January 17, 2024
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If you want to tackle home improvements, consolidate high-interest debt or cover the cost of college, cash-out refinancing could be the solution. This type of refinancing turns home equity into spendable capital, while also potentially securing more favorable mortgage terms.
Whether cash-out-refinancing is a good idea or not, however, depends on your creditworthiness, financial goals and overall situation. Besides the strict credit and other eligibility criteria — and thousands of dollars in potential closing costs — refinancing could be harmful, particularly if it means giving up a lower interest rate on your current home loan.
Cash-out refinancing also isn’t the only way to tap equity or borrow for a large and necessary expense, so consider the alternatives as you learn how cash-out refinancing works and if it makes sense for you.
What is a cash-out refinance?
When you execute a cash-out refinance, you replace your current mortgage with a new loan that’s larger than the outstanding balance of your existing mortgage. You then “cash out” the difference as a lump sum. Those funds can be used for essentially anything you want.
“Cash-out refinances can be used for many purposes such as a tool to consolidate other higher-interest debt, completing home improvements, or any other instances where cash on hand can be helpful,” said Darren Tooley, a senior loan officer at Cornerstone Financial Services in Southfield, Michigan.
Cash-out refinancing is generally available for conventional, Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) mortgage loans.
For comparison, a traditional rate-and-term refinance refers to taking out a new mortgage loan and using the proceeds to pay off your existing mortgage. Though you can’t get cash out via a rate-and-term refinance, you could still change the terms of your loan, whether it’s getting a lower interest rate or shortening or lengthening the repayment period.
Pros and cons of a cash-out refinance
If you’re considering a cash-out refinance, it’s important to weigh the major pros and cons to ensure it’s worth it.
Pros
- Lump sum of cash: One of the biggest advantages to a cash-out refinance is you can leverage your home equity to get a large sum of cash fairly quickly to use for various purposes.
- Predictable payments: Relying on credit cards or other lines of credit means you’re stuck with variable and high-interest. With cash-out refinancing, you have a single monthly mortgage payment to worry about, which is often a fixed-rate loan (but could also be an adjustable-rate mortgage).
- Potential tax deduction: If you use the funds from a cash-out refinance to pay for certain home renovations, the interest on the loan may be tax-deductible.
Cons:
- Higher mortgage balance: A major downside of cash-out refinancing is that it increases the overall amount you owe on your mortgage and temporarily reduces your home equity.
- Higher rates: Cash-out refinancing loans tend to have higher interest rates than traditional mortgages and rate-and-term refinances, since there’s added risk when increasing the size of your loan.
- Cash-out refinance closing costs: Similar to taking out a home loan, you’ll likely have to pay 2% to 6% of the new mortgage amount — a $200,000 refinance could cost $4,000 to $12,000 — plus cover a hundreds-of-dollars appraisal.
- Risk to home: Your property serves as the collateral for the loan. So if you can’t make your mortgage payments for whatever reason, you could risk losing your home to foreclosure.
How does a cash-out refinance work?
The process of a cash-out refinance works similarly to a regular rate-and-term refinance. The difference is you receive a lump sum of cash at the end.
That cash is backed by the equity in your home, which is the difference between the market value of your home and the outstanding balance of all liabilities on the property (such as the original mortgage).
“Equity is built over time by a combination of the home value appreciating while also paying down your current mortgage,” said Tooley.
How much can you get from a cash-out refinance?
The amount of money you can get with a cash-out refinance depends on how much equity you have in your home.
“It’s important to keep in mind that not all your available equity can be accessed with a cash-out refinance, as most programs don’t allow you to finance more than 80% of the home’s appraised value on a primary residence,” said Tooley.
Be aware: If you’re approved for an amount larger than 80%, you may have to pay private mortgage insurance (PMI) until you reach 20% equity again. Freddie Mac estimates it can cost $30 to $70 per month for every $100,000 on your loan balance.
The exact amount you can borrow via cash-out refinancing also depends on the type of loan you pursue, the type of property, as well as your personal credit and financial profile. The following table breaks down the maximum loan-to-value ratio (LTV) you can generally expect for cash-out refinancing.
| Type | Maximum borrowing amount |
|---|---|
Conventional loan
| 70% to 80%
|
FHA loan
| 80%
|
Veterans Affairs (VA) loan
| Up to 100%
|
Consider this example: Say you own a home that’s worth $300,000. You still owe $150,000 on a conventional mortgage. That means you have $150,000 in home equity (assuming there are no other liens on the property).
Maybe you’d like to leverage some of that equity to pay for your child’s private school tuition. In this scenario, you could apply to refinance up to $240,000 (80% of $300,000). If approved, you’d use $150,000 (your equity) to pay off your existing mortgage and pocket the remaining $90,000, which you could then use to cover the tuition bill — or another expense. You’re not obligated to cash out the full amount if you don’t need it.
Cash-out refinance eligibility requirements
If you’re interested in a cash-out refinance, you’ll need to meet certain requirements to get approved. Exact requirements vary by mortgage refinancing lender, but in general, expect the following:
- Age of loan: If you’re using a cash-out refinance to pay off an existing first mortgage, that loan must be at least 12 months old at the time of refinance.
- Length of occupancy: At least one borrower must have been on the loan agreement for a minimum of six months before refinancing.
- Loan-to-value (LTV): As mentioned, most lenders won’t let you borrow more than 80% of your home’s value. However, there are cases when you may be able to borrow more, especially if you have strong credit and sizable assets.
- Credit score: In many cases, you’ll need a credit score of at least 640 to qualify. However, a score of 680 to 700 (or higher) is ideal, especially if you have a higher LTV ratio. These requirements are more relaxed for FHA (500 to 580 credit score) and VA loans (no minimum).
- Debt-to-income ratio (DTI): Your DTI is a measure comparing your monthly debt obligations and your monthly gross income, expressed as a percentage. Ideally, your DTI for cash-out refinancing should be no more than 36%. Some lenders will approve cash-out refinancing with a DTI up to 45% or higher, particularly if you have excellent credit and/or several months’ worth of cash reserves.
How to prepare for and get a cash-out refinance
Since the interest rate on a cash-out refinance will likely be higher than on a rate-term refinance, Tooley said it’s important to make sure you’re in good financial health to maximize the benefits.
“You will want to make sure your credit score is in the best possible shape prior to a cash-out refinance to keep your interest rate as low as possible, while also maximizing the amount of cash you can receive,” he said.
If your credit isn’t in great shape, you may want to improve it before applying. That might mean paying down some of your existing debt or fixing any errors on your credit reports. (Start by requesting your free reports via AnnualCreditReport.com.)
Tooley also recommended trying to maximize your home’s appraised value, since that will have a direct impact on the amount of cash you can receive.
“Doing simple things like sprucing up the home with a deep clean and fresh paint, decluttering and adding some landscaping can increase the curb appeal of your home, which can influence the appraiser and maximize the appraised value of your home,” he said.
| Steps to getting a cash-out refinance |
|---|
|
Alternatives to a cash-out refinance
A cash-out refinance isn’t the only option to borrow a large sum of cash to cover major expenses — and it isn’t always the best one either. Alternatives include:
Home equity loan
Best for: Homeowners with significant equity
Also known as a second mortgage, a home equity loan is an installment loan that borrows against the equity in your home. These loans typically offer a lump sum of money, which is repaid over a fixed period, much like a traditional mortgage. One key benefit is that you keep your current mortgage, and its rate and terms.
Home equity line of credit (HELOC)
Best for: Homeowners who want a more flexible borrowing option
A HELOC is another borrowing option that taps into your home’s equity, but it works more like a credit card. You’re given a line of credit that you can borrow against and pay down as needed, up to a certain limit, during what’s known as the draw phase. Once the draw phase ends, you’re no longer able to borrow against the line of credit and must start paying down the balance. Like a home equity loan, you keep your current mortgage.
Personal loan
Best for: Homeowners who don’t want to use their home as collateral
A personal loan is an installment loan that you can use for almost any purpose, such as debt consolidation or home improvements. A personal loan can be either secured, meaning it’s backed by collateral, or unsecured, which can be a good option if you don’t want to risk any assets.
Personal loans usually have shorter repayment terms (generally, two to seven years) and higher interest rates than home equity loans and HELOCs, however. The average rate on a personal loan with a two-year repayment term in was 12.17%, according to the latest Federal Reserve data.
Bottom line: You have several choices when it comes to borrowing money. If you’re a homeowner, your home’s equity could be a great source of low-interest financing. That said, carefully consider whether cash-out refinancing makes sense for you; compare interest rates, terms and fees from several lenders and calculate the long-term costs. It may turn out that an alternative borrowing method works out better in the long-run.
Frequently asked questions (FAQs)
Yes, cash-out refinance rates tend to be slightly higher than rate-and-term refinance rates due to the increased risk associated with borrowing a larger amount.
The fees associated with a cash-out refinance are comparable to those of a traditional mortgage or refinance. Namely, expect to pay closing costs of 2% to 6%, and an appraisal fee in the hundreds of dollars.
The funds you receive from cash-out refinancing are not taxable, since they are a loan and not income. However, if you use the funds to pay for certain home renovations, you may be able to deduct the interest on your tax return. Consulting your tax advisor is always a good idea.
Typically, you’ll need to wait at least six months after a home purchase to cash-out refinance. Once you’re eligible for a cash-out refinance, you can expect to complete the process within 45 to 60 days.
Editorial Disclaimer: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, airlines, hotel chain, or other commercial entity and have not been reviewed, approved or otherwise endorsed by any of such entities.
This content is for educational purposes only and is not intended and should not be understood to constitute financial, investment, insurance or legal advice. All individuals are encouraged to seek advice from a qualified financial professional before making any financial, insurance or investment decisions.
Note: While the offers mentioned above are accurate at the time of publication, they're subject to change at any time and may have changed or may no longer be available.
