A cash-out refinance is a new mortgage in which the loan amount exceeds what’s owed on your existing mortgage. You receive the difference between the two loans in a lump sum and can use the funds for any purpose.
Let’s say your home is worth $350,000 and you have a $150,000 mortgage, which means you have $200,000 in available home equity. You want to borrow half of that amount ($100,000), so you decide to refinance into a $250,000 mortgage and pocket the extra $100,000 in cash.
Mortgage refinance lenders usually require you to have at least 20% equity — or a maximum 80% loan-to-value (LTV) ratio — to qualify for a cash-out refinance.
Using the example above of a $350,000 home with a $150,000 mortgage balance, you’d have roughly 57% equity before refinancing. After refinancing into a new $250,000 mortgage, you’d have about 29% equity remaining. While you only tapped $100,000, you could’ve accessed up to $130,000 and still retained 20% equity.
A cash-out refinance calculator can give you an estimate of how much equity you can access, based on your home value and LTV ratio. However, it’s best to avoid overborrowing by only tapping the equity you actually need.
A cash-out refinance serves two purposes: improving your mortgage terms and allowing you to borrow against your home equity.
This differs from a traditional “rate-and-term refinance,” which involves making changes to your mortgage rate or repayment term. You could use this type of refinance to switch from an adjustable-rate mortgage to a fixed-rate mortgage, shorten your loan term from a 30-year to a 15-year loan or simply get a better mortgage rate and save on your monthly payments.
Before you leverage your home equity through a cash-out refinance, you first need to know for what purpose you’ll use those funds. Common reasons to use a cash-out refi include:
If you’re interested in a cash-out refinance for a conventional loan or one backed by the Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA), you must meet the following general requirements to qualify:
*You may still qualify with a slightly higher DTI ratio if you have a higher credit score or more home equity.
You can also expect to pay for a home appraisal to verify your home’s value.
NOTE: Loans insured by the U.S. Department of Agriculture (USDA) aren’t eligible for cash-out refinancing.
A cash-out refinance is just one of a few ways that homeowners can tap their equity; another option is a home equity loan.
A home equity loan is a lump sum that is repaid in fixed monthly installments. It’s also called a second mortgage, because it’s second in line to be repaid — after the first mortgage used to buy your home — if you lose your home to foreclosure.
While a cash-out refinance replaces your existing mortgage, you’ll keep your current loan intact but add another monthly payment by taking out a home equity loan. Home equity loans also tend to have higher interest rates than cash-out refi rates.
You’ll pay closing costs with both loan types.
Besides the home equity loan option discussed above, here are a few other alternatives to a cash-out refinance:
It can take several days after your refinance closes to receive your cash. There’s a three-business-day right of rescission on refinance loans, which allows you to cancel the transaction for any reason. If you decide to move forward, your new lender will then pay off your old loan and you’ll receive your cashed-out equity after that point.
Since you’re taking out a new loan to replace your existing mortgage, your credit score and history will be impacted. New credit makes up 10% of your credit score and affects the length of your credit history. This change typically causes a drop in your credit score.
A limited cash-out refinance also replaces your current mortgage, but only for a slightly higher amount to cover the closing costs. You’re allowed to receive up to $2,000 or 2% of your new loan amount in cash, whichever is less. The cash doesn’t come from your home equity, but from the difference between the estimated and final loan payoff amounts.
Yes, you can sell your home after going through the cash-out refinance process. However, it’s best to calculate your break-even point — the amount of months it would take for you to recoup your refi closing costs — before selling. If you decide to sell before then, you’ll essentially lose money with a refi.
Yes, you may qualify for a cash-out refinance on a second home or an investment property, but you won’t be able to borrow as much equity. Lenders limit the LTV ratio for cash-out refis on second homes and investment properties to 75%, meaning you’ll need at least 25% equity after closing.
A cash-out refinance may impact your mortgage interest deduction, which allows you to deduct the loan interest you paid over the year from your taxable income. Unless you use your cashed-out equity to cover a home improvement project on the home that secures the refinanced loan, you won’t be able to deduct the interest you pay on that portion of your loan. You may still deduct the interest paid on the remaining portion of your loan, though.