Cash-out refinance: How it works and when to do it

Key takeaways

• Cash-out refinancing allows you to turn equity into cash through refinancing your mortgage.

• While you can’t cash out all of your home's equity, the process gives you access to a larger sum of money without needing to sell your home.

• The terms of your refinanced mortgage might significantly differ from your original loan, including a new rate or longer or shorter loan term.

Paying down your mortgage helps build equity in your home, but you don’t have to wait until you completely repay it, or sell the property, to access that equity. Instead, you can convert the equity you have into cash, and continue paying off your mortgage, with cash-out refinancing.

What is a cash-out refinance?

A cash-out refinance turns your home’s equity into cash by replacing your current mortgage with a new, larger mortgage. The difference between the two is given to you in a lump-sum payment. You can use this money for any purpose, including home remodeling, consolidating higher-interest debt, college tuition and other financial needs.

Cash-out refinance example

Let’s say the remaining balance on your current mortgage is $100,000, and your home is currently worth $300,000. In this case, you’d have $200,000 in home equity.

Say you want to take equity out to renovate your kitchen and bathrooms. To be eligible for a cash-out, you’d need to maintain at least $60,000 in equity (20 percent of $300,000), leaving you up to $140,000 to cash out if you choose.

Say your kitchen and bathroom reno budget is $120,000. You decide to refinance and take out $130,000 in cash. This replaces your old mortgage of $100,000 with a new mortgage of $230,000 at a new interest rate. Your lender charges 1 percent of that amount in closing costs, or $2,300. All told, you’ll take home $127,700 in equity funds.

How much cash can you get with a cash-out refinance?

For conventional loans, mortgage lenders typically allow you to borrow up to 80 percent of the home’s value with a cash-out refinance. However, this threshold varies depending on the property type. For a multifamily home, for example, you can only borrow up to 75 percent.For an FHA loan cash-out refinance, you might be eligible to borrow up to 80 percent of the value of your home. For a VA loan cash-out, you could qualify to tap all of your home’s equity.

How does a cash-out refinance work?

The process for a cash-out refinance is similar to that of a regular refinance (a rate-and-term refinance), in which you simply replace your existing loan with a new one, usually at a lower interest rate or for a shorter loan term, or both. The difference: You’ll get a new loan for a larger amount that includes the balance of the old loan and cash you withdraw from your home’s equity.The process involves:

1. Figuring out how much cash you need: Because you need to repay the new mortgage with interest, it’s best to know how much you need to withdraw and for what purpose, rather than cashing out an amount you think you might use. Cash-out refinances are generally best for big-ticket costs: Think home renovations or major debt consolidation.

2. Determining whether you qualify: Many cash-out refinance lenders require a credit score of at least 620 and at least 20 percent equity in your home. You might find lenders with looser requirements, but you could pay a higher rate as a result.

3. Shopping around for the best cash-out refinance rates: Compare at least three different lenders to get a sense of what you qualify for and what rates look like today. If you can’t get a lower rate than the one you have now, it might not make sense to tap your home’s equity at this time.

— Greg McBride, Bankrate Chief Financial Analyst

Pros and cons of cash-out refinancing

Pros of cash-out refinance

• You can lower your interest rate: This is the most common reason most borrowers refinance, and it makes sense for cash-out refinancing as well. Obviously, you want to pay as little interest as possible when taking on a larger loan.

• Your cost to borrow could be lower: Cash-out refinancing is often a less expensive form of financing because mortgage refinance rates are typically lower than rates on personal loans (like a home improvement loan) or credit cards. Even with closing costs, this can be especially advantageous when you need a significant amount of money.

• You can improve your credit: If you do a cash-out refinance and use the funds to pay off debt, you could see a boost to your credit score if your credit utilization ratio drops.

• You can take advantage of tax deductions: If you plan to use the funds for home improvements and the project meets IRS eligibility requirements, you could take advantage of the interest deduction at tax time.

Cons of cash-out refinance

• Your interest rate might go up: A general rule of thumb is to refinance to improve your financial situation and get a lower rate. If cash-out refinancing increases your rate, it’s probably not a smart move.

• You might need to pay PMI: Some lenders allow you to withdraw up to 90 percent of your home’s equity, but doing so might mean paying for private mortgage insurance, or PMI, until you’re back below the 80 percent equity threshold. That can add to your overall borrowing costs.

• You could be making payments for decades: If you’re using a cash-out refinance to consolidate debt, make sure you’re not prolonging debt repayment over decades when you could have paid it off much sooner and at a lower total cost otherwise. “Keep in mind that the repayment on whatever cash you take out is being spread over 30 years, so paying off higher-cost credit card debt with a cash-out refinance may not yield the savings you’re thinking,” says Greg McBride, chief financial analyst for Bankrate. “Using the cash out for home improvements is a more prudent use.”

• You have a greater risk of losing your home: No matter how you use a cash-out refinance, failing to repay the loan means you could wind up losing it to foreclosure. Don’t take out more cash than you absolutely need, and ensure you’re using it for a purpose that will ultimately improve your finances instead of worsening your situation.

• You might be tempted to use your home as a piggy bank: Tapping your home’s equity to pay for things like vacations indicates a lack of discipline with your spending. If you’re struggling with getting your debt or spending habits under control, consider seeking help through a nonprofit credit counseling agency.

Is a cash-out refinance right for you?

Mortgage rates are higher than they’ve been in recent years. Still, the collateral involved in a cash-out refinance — your home — means that lenders take on relatively little risk and can afford to keep refinance rates somewhat affordable. That means that cash out refinancing is one of the cheapest ways to pay for large expenses. Many borrowers use the proceeds for the following reasons:

• Home improvement projects: You could use a cash-out refinance to renovate your home or add an addition, for example.

• Investment purposes: You could purchase an investment property using a cash-out refinance.

• High-interest debt consolidation: Refinance rates tend to be lower compared to other forms of debt like credit cards. A cash-out refinance allows you to pay these debts off and pay the loan back with one, lower-cost monthly payment instead.

• College education: Tapping into home equity to pay for college can make sense if the refinance rate is lower than the rate for a student loan.

Cash-out refinance FAQ

• What are the requirements for cash-out refinance?

  Just as you did with your original mortgage, you’ll need to meet qualifying criteria to be eligible for a cash-out refinance. These requirements include:
  
  

  • Credit score: Generally at least 620

  • Debt-to-income (DTI) ratio: 43% or lower

  • Equity: 20%, although lower in some cases

• How much are the fees for a cash-out refinance?

  The closing costs on a cash-out refinance (and any type of refinance) are almost always less than the closing costs on a home purchase. For a cash-out refinance, the lender charges an appraisal fee, and might charge an origination fee, often a percentage of the amount you’re borrowing. With a cash-out, you’re getting a larger loan, so the origination fee reflects that.

• How does a cash-out refinance affect my taxes?

  A cash-out refinance might be eligible for mortgage interest tax deductions so long as you’re using the money to improve your property. Some acceptable home improvement projects might include:
  
  

  • Adding a swimming pool or hot tub to your backyard

  • Constructing a new bedroom or bathroom

  • Erecting a fence around your home

  • Enhancing your roof to make it more effective against the elements

  • Replacing windows with storm windows

  • Setting up a central air conditioning or heating system

  • Installing a home security system

  In general, the improvements should add value to your home or make it more accessible. Check with a tax professional to see whether your project is eligible.

• What is the difference between a cash-out refinance and home equity loan?

  Both a cash-out refinance and a home equity loan allow borrowers to tap their home’s equity, but there are some major differences. Cash-out refinancing involves taking out a new loan for a higher amount, paying off the existing one and obtaining the difference in cash. A home equity loan, in contrast, is a second mortgage. It doesn’t replace your first mortgage and can sometimes have a higher interest rate compared to a cash-out refinance.

• What are alternatives to cash-out refinancing?

  • HELOC: A home equity line of credit, or HELOC, allows you to borrow money when you need to with a revolving line of credit, similar to a credit card. This can be useful if you need the money over a few years for a renovation project spread out over time. HELOC interest rates are variable and change with the prime rate.

  • Home equity loan: A home equity loan gives you a lump-sum payment just after closing. Like a HELOC, it’s a second mortgage secured by your home. Unlike a HELOC, home equity loans have a fixed-rate and you start repaying them immediately.

  • Personal loan: A personal loan is a shorter-term loan that provides funds for virtually any purpose. Personal loan interest rates vary widely and can depend on your credit, but the money borrowed is typically repaid with a monthly payment, like a mortgage. Unlike a refinance, they can require less paperwork and can be approved and funded the same day you apply.

  • Reverse mortgage: A reverse mortgage allows homeowners aged 62 and up to withdraw cash from their homes. The balance doesn’t have to be repaid as long as the borrower lives in and maintains the home and pays their property taxes and homeowners insurance.

• Will I have to get a home appraisal for cash-out refinance?

  Yes, in most cases. The mortgage lender needs to know what your home is worth to calculate how much equity you have.

• How will my monthly mortgage payment change after refinancing?

  Your payment could change depending on a couple factors: the rate you’re refinancing to and how much equity you’re pulling out. If you’re refinancing to a much lower rate, you could end up with a similar payment, even with taking on a larger loan. Conversely, if the rate is similar or higher to your current one, your payment will go up because the loan amount has increased.