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How Does a Cash-Out Refinance Work?

cash out refinance

One of the most powerful financial tools you have as a homeowner is the ability to tap your home’s equity. A cash-out refinance is simply replacing your current loan with a bigger loan and pocketing the difference as cash.

It’s important to understand the risks and benefits of borrowing against your home’s equity with a cash-out refi.

In this article:

What is a cash-out refinance?

A cash-out refinance is taking out a new mortgage for more than you owe on your existing loan and receiving the difference in a lump sum. The money can be used for any purpose — to make home improvements, pay off high-interest debt or help your child pay for college tuition.

How does a cash-out refinance work?

The process for a cash-out mortgage is similar to that of a new purchase loan. Your lender will verify your income, employment, credit, debts and assets, and order an appraisal to determine your home’s value.

Once the appraisal comes back, you can decide how much equity to tap for your financial goals. Lenders generally limit the amount of cash you can access to 80% of your home’s value.

For example, let’s say your home is worth $400,000 and you owe $200,000 on your mortgage, meaning you have $200,000 in equity. In a cash-out refinance, you could borrow $320,000 and pocket $120,000 of that in cash. However, it’s better to pull out only what you need to avoid overborrowing.

A cash-out refinance calculator can help give you a rough idea of how much equity you can access based on the maximum loan-to-value ratio (LTV). The LTV ratio is a measure of the loan amount compared to the value of your home; maximum LTV ratios vary by loan program.

Reasons you might need a cash-out refinance

One of the first questions a lender will ask when you apply for a cash-out refinance is how you’ll use the money.

Let’s look at some of the most common reasons for a cash-out loan:

Reason for cash-out refinance What it’s best for
Home improvement Covering the cost of home repairs and upgrades, and potentially increasing the value of your home.

Added bonus: Cash-out refinancing for home improvements may be tax-deductible.

Debt consolidation Reducing your monthly debt by paying off high-interest credit cards, student loans or car payments that have become unaffordable.
Pay for major life events Paying for major expenses such as college tuition or starting a small business, often at lower borrowing costs than other types of financing.
Purchase investment property or vacation home Putting a down payment on a second home, or an investment property that will generate an income.

How much does a cash-out refinance cost?

Closing costs for a cash-out refinance and other mortgages average about 2% to 6%, depending on your loan size. Because you’re borrowing more than your current loan balance, the fees may be higher than what you paid for your current mortgage. Your cash-to-close can be deducted from the proceeds of your loan, rather than paid out of pocket.

Homeowners insurance and title insurance premiums are tied to both your home’s value and the new loan balance. You may see a slight increase in those expenses if your cash-out loan amount is significantly higher than your previous loan amount. You’ll want to stay in your home long enough to recoup closing costs, known as the breakeven point. If you sell before your breakeven, you’ll lose money on a cash-out refi.

Below is a breakdown of average refinance closing costs, according to data from a ValuePenguin report. LendingTree is the parent company of ValuePenguin.

Type of fee Average cost
Mortgage application fee $235
Property appraisal fee $480
Loan origination fee 1% of the loan amount
Attorney and escrow fees $275
Title search and title insurance $733 (may vary based on the loan amount)
Local recording fee $138
Reconveyance fee $58

 

One important note about your escrow account: If your property taxes and insurance are currently part of your monthly mortgage payment, the lender will need to set up a new escrow account, which could increase the amount of cash needed at closing. Federal law requires lenders to refund any balance in your current escrow account within 20 days of your loan payoff date.

Cash-out refinance pros and cons

The best cash-out refinance loan matches your credit and debt situation with how much equity you can tap to accomplish a financial goal. There are a number of programs available for cash-out refinancing, and we’ll discuss the features of each to help you decide which might be the best fit for your funding needs.

Conventional cash-out refinance

A conventional cash-out refinance is best if you have a credit score over 620, stable income, and want to borrow up to 80% of your home’s value. Here’s a look at some benefits and drawbacks of conventional cash-out refinancing.

Pros

No mortgage insurance. One of the big advantages of a conventional cash-out mortgage is you don’t need mortgage insurance. Private mortgage insurance PMI is required if you have less than 20% equity in your home, and it protects the lender in the event you default.

Less expensive appraisals. Conventional appraisals, which usually cost between $300 and $400, tend to be cheaper than government-insured loan appraisals.

Get cash from vacation homes and rental properties. If you want to tap equity from a rental property or a vacation home, conventional financing is your only cash-out loan option; government-insured mortgages only allow cash-out refis on primary residences.

Cons

Tougher to qualify for. Your interest rate is dependent on your credit scores, and your debt-to-income (DTI) ratio can’t be more than 50%. DTI is a measure of your total monthly debt payments compared to your gross monthly income.

Cash-out refinance mortgage rates may be higher. The more equity you borrow in your home, the more risk it poses to the lender if you default and they have to foreclose. As a result, lenders mark-up mortgage rates on higher LTV cash-out refinances, and if your credit scores are lower, expect an even higher interest rate — especially on conventional loans.

FHA cash-out refinance program

The Federal Housing Administration (FHA) insures FHA loans, and you can do a cash-out refi on a primary home, with an LTV maximum of 80%. For borrowers who need a cash-out refinance with bad credit, an FHA cash-out may be the best option.

Pros

Lower credit score requirements. You can borrow the maximum cash-out amount — even with a credit score as low as 500. Many lenders will require a credit score of 580 or higher.

You might be able to qualify with more debt. Some borrowers with a DTI above 50% can be approved with compensating factors, such as a high credit score and significant cash reserves.

Cons

You’ll pay two types of mortgage insurance. FHA mortgage insurance is required on all loans regardless of how much equity you have. You’ll pay an annual mortgage insurance premium (MIP) as part of your monthly payment and an upfront mortgage insurance premium (UFMIP) of 1.75% that’s typically financed over the life of your loan.

Loan amounts are capped based on where you live. You won’t be able to exceed the maximum FHA loan limit for your county. This may limit the amount of cash you can take out.

VA cash-out refinance loans

Loans guaranteed by the U.S. Department of Veterans Affairs (VA) include an option for cash-out refinancing with easy qualifying guidelines for eligible active-duty military service members, veterans and their spouses. VA borrowers can tap 90% of their home’s equity, down from 100% after the guidelines changed in late 2019.

Pros

No minimum credit score requirement. There is no minimum credit score requirement for VA cash-out refis, but many VA-approved lenders require a credit score of 620 credit score or higher.

No DTI requirement. Although the VA guidelines recommend a DTI of 41%, ultimately, VA-approved lenders look at how much a military borrower and his family have left over after taxes and home maintenance costs or “residual income,” versus the standard DTI requirement of FHA and conventional loans.

No mortgage insurance. VA cash-out refinance guidelines don’t require mortgage insurance, however, a VA funding fee is charged unless the borrower has a service-related disability. The VA funding fee helps offset the cost of the VA loan program to taxpayers.

Cons

More expensive appraisals. VA appraisals tend to be more expensive than FHA or conventional appraisals because fees are set by the VA based on where you live. This can also result in a longer wait to complete a VA cash-out refinance, as the VA also sets its own appraisal turnaround time frames.

Repairs and additional inspections might be needed. VA has minimum property requirements that must be met, which means you might have to complete repairs if the appraiser recommends them. Depending on the state you live in, you may also need pest or well inspections.

Risks of cash-out refinancing

Using your home equity can make good financial sense for certain goals, but it comes with risks, too. Here are a few to consider:

  1. Potentially losing your home.
  2. Depleting your home’s equity.
  3. Enabling bad spending habits.
  4. Adding to your overall debt and interest payments.

The example below shows the costs of replacing a $200,000, 30-year fixed loan at a current rate of 4.25% with a $250,000 cash-out refinance mortgage at a rate of 3.75%.

Current payment New payment Total extra mortgage payments over 30 years Total extra interest paid over 30 years
$983.88 $1,157.79 $173.91 x 360 months = $62,607.60 $12,607.67

 

The results show the true cost of a cash-out refi: An increase in your monthly payment that adds up to more than $62,000 over 30 years and more than $12,600 in added interest charges. Plus, if you need to sell your home, you’ll have $50,000 less in equity, resulting in a lower net profit at the closing table.

Before you finalize any paperwork for a cash-out refinance, go through the costs, benefits and risks with a loan officer. You could avoid solving a short-term problem with a decision that has long-term financial consequences.

Alternatives to a cash-out refinance

Before you pursue a cash-out refinance, here are other options to consider.

Home equity line of credit

If you don’t need a large lump sum, a home equity line of credit (HELOC), which works like a credit card with an adjustable interest rate, may be a better choice. With a HELOC, there aren’t any limitations on their use, and you’ll only pay interest on the amount of credit used.

For instance, if you take out a $10,000 HELOC, but only need to use $5,000 right now, you’ll only pay interest on the $5,000 in use. With a cash-out refinance, you’ll pay interest on the entire loan balance.

Home equity loan

With a home equity loan, you can borrow a lump sum of cash and repay it in monthly installments. Interest rates on home equity loans are generally fixed, so the rates are typically higher than rates available for HELOCs.

Both HELOCs and home equity loans are secured by your home, which puts you at risk of foreclosure if you get behind on payments. Leaving an extra cushion of home equity is also a good hedge against any downturns in local real estate markets, reducing the chance you’ll end up with loan balances higher than your home’s value.

Personal loan

Personal loans are unsecured loans that can be used for any purpose, including home improvements, debt consolidation or other major expenses. Personal loans generally come with shorter terms than mortgages, usually two to seven years. Interest rates are typically higher for personal loans than most mortgages, but since you’re borrowing the money for a shorter term, you may still pay less over its life than with a cash-out refinance.

 

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