Cash-Out Refinance: How It Works and When It’s a Good Idea

A cash-out refinance allows you to convert your home equity into a lump sum of cash. By borrowing more than you currently owe on your mortgage, you can pay off the old loan and pocket the difference. Use those funds to pay off credit cards, spruce up an outdated kitchen or cover a big expense like college tuition or a business venture — it’s totally up to you.

What is a cash-out refinance?

A cash-out refinance is when you take out a new mortgage that will pay off your existing home loan with a significant amount of money left over. The difference between what you owe on your old loan and what you borrow is yours to take as a lump sum in cash. One important thing to remember is that the amount you can borrow is based on the amount of equity you have in your home —and you can’t borrow all of your home’s equity.

Cash-out refi example

Let’s say your home is worth $450,000 and you currently owe $300,000. You have $150,000 of home equity. However, most cash-out refinance programs limit you to borrowing 80% of your home’s value — which means you’d only be able to borrow up to $60,000 of your total $150,000 in equity.

How does a cash-out refinance work?

It takes a little extra legwork to complete a cash-out refinance versus a regular refinance. In most cases, you’ll follow these basic steps to convert your home’s equity to cash:

1. VERIFY YOU CAN AFFORD THE LOAN

Because you’re taking out a larger loan than you currently owe, lenders will vet your income, assets and credit to verify you can afford your new monthly payment amount. Usually a cash-out refi will make your monthly payment more expensive, although in some cases you could come out with lower mortgage payments if interest rates have dropped significantly since your first loan.

2. VERIFY HOW MUCH YOUR HOME IS WORTH

A home appraisal is generally required to confirm your home’s value. A real estate appraiser will compare your home to recently sold homes in your area with similar features and provide an opinion of value.

  If you already have a government-backed loan, you may be able to refinance without an appraisal. If your current loan is an FHA or USDA loan, you would use a streamline refinance loan. If it’s a VA loan, look into an interest rate reduction refinance loan (IRRRL).

3. VERIFY THE MAXIMUM YOU CAN BORROW

It’s common for lenders to allow you to borrow up to 80% of your home’s value. This is also called your loan-to-value (LTV) ratio maximum because it measures how much of your home’s value is being borrowed. However, eligible military borrowers may be able to tap up to 90% of their home’s value with a VA cash-out refi.

4. FINALIZE YOUR CASH-OUT AMOUNT

The lender will finalize your total cash out by subtracting your current mortgage balance and any closing costs you owe from the loan amount.

Requirements for a cash-out refinance

If you have enough equity to qualify for a cash-out refinance — in most cases you’ll need at least 20% — you’ll also need to meet the cash-out refinance requirements for income, credit and assets set by each program. Here are some general guidelines:

→  Credit score requirements. Conventional loan guidelines require a credit score of at least 620 for cash-out refinances, though some lenders may set a higher credit score requirement for their cash-out refinance products. If your score falls short, you may need to stick with an FHA loan backed by the Federal Housing Administration (FHA), which comes with more lenient credit minimums.

→  Debt-to-income (DTI) ratio. Your DTI ratio is a measure of your total debt divided by your pretax income, and it carries significant weight when you’re borrowing more than you currently owe. The Consumer Financial Protection Bureau (CFPB) recommends a maximum 43% DTI ratio, but lenders may make exceptions if you have high credit scores or extra savings.

→  The occupancy of the house you’re refinancing. Most borrowers take out cash against their primary residence, that is, the home they live in. However, conventional loans also allow you to borrow money against the equity in an investment property or second home. Just be aware that you may pay a higher interest rate and be limited to a lower LTV ratio.

→  The number of units in your home. You’ll get the most cash out of a one-unit, single-family home; lower LTV limits apply to two-to-four-unit homes. The table below gives you a glance at the qualifying requirements for different loan types, assuming you’re taking cash out of a single-family primary residence.

Cash-out refinance rates

You’ll typically pay a slightly higher rate for a cash-out refinance than for other loans because lenders consider an equity-tapping refinance riskier than a regular refinance. There are four main factors that affect what cash-out refinance rates you’ll be offered:

→  Your credit scores. Although lenders increase the rates for everyone on cash-out refinances, a low credit score will also have a big impact on how high your rate is. A 760 credit score will get you the best rate, while a 620 score could make your rate over 1.5 percentage points higher.

→  Your LTV ratio. The higher your LTV ratio, the more risky your loan is considered to be, and therefore the more expensive your interest rate will be.

→  Your property type. You’ll pay extra to tap equity from a two-to-four-unit property or a condominium.

→  Your occupancy. Lenders charge higher cash-out refinance rates for second homes and investment properties.

How much can I get from a cash-out refinance?

As mentioned above, in most cases you can borrow up to 80% of your home’s value, although borrowers with VA loans have a little extra cash-out borrowing power.

CONVENTIONAL LOANS

With guidelines set by Fannie Mae and Freddie Mac, you’ll be able to borrow up to 80% of your home’s value. An added bonus: You won’t pay mortgage insurance, which provides lenders with financial protection if you default on your home loan.

FHA LOANS

Backed by the Federal Housing Administration (FHA), an FHA cash-out refinance allows you to borrow up to 80% of your home’s value with credit scores as low as 500. The catch: You’ll pay expensive FHA mortgage insurance regardless of how much equity you have.

VA LOANS

Designed for eligible military borrowers, VA loans are guaranteed by the U.S. Department of Veterans Affairs (VA). VA cash-out refinance loans allow you to borrow up to 90% of a home’s value. You won’t pay mortgage insurance on a VA cash-out refinance. Instead, the VA charges a funding fee between 2.3% and 3.6% of your loan balance, unless you’re exempt because of a disability related to your military service.

Maximum cash-out example

Here’s how the cash-out options would look for a cash-out refinance on a $450,000 home with a 6% mortgage interest rate and a current mortgage balance of $300,000:

Is a cash-out refinance a good idea? Pros and cons

Pros

  You can use the cash-out equity for any purpose. Whether you want to consolidate debt, invest in real estate or use the cash for something else, your home equity can be used as you see fit.

  You can expect a lower interest rate compared to other home equity financing options. Mortgages typically have lower interest rates than credit cards, personal loans and home equity loans, which puts more room in your monthly budget.

  Your interest charges may be tax-deductible. If you use your funds for home improvements on a primary residence or second home, you may get a tax break when you file your taxes.

Cons

  You’ll need at least 20% equity to qualify. If home values have tumbled in your area or you recently purchased your home with a small down payment, a cash-out refinance may not be possible right now.

  You’ll lose some of the equity you’ve built. Borrowing against your home equity now means you’ll make a smaller profit when you sell your home later.

  You’ll have a higher monthly mortgage payment. In most cases, a higher loan amount will mean a higher monthly mortgage payment for as long as you own your home.

  You may pay a higher rate than you would with a different type of refinance. Cash-out refinances typically have higher rates than rate-reduction refinances. If you have a low credit score, you can expect an even higher rate if you’re tapping equity.

HELOC vs. cash-out refinance

A home equity line of credit (HELOC) is a little bit like a credit card — you can borrow up to a certain maximum amount as needed. The draw period, during which you can access the money, usually lasts 10 years, and during this time you may pay only interest on the borrowed funds. The line of credit is secured by your home equity, and you’ll repay it once the draw period ends. In many cases, the repayment period is quite long — around 20 years.

A HELOC makes sense if: You have a relatively high credit score, you don’t need access to the full amount of funds all at once, or you want an interest-only period.

A cash-out refinance makes sense if: You want the lowest possible monthly payment, you have low credit, or you need a stable monthly payment that won’t fluctuate.

Cash-out refinance vs. home equity loan

Another way to tap your home equity is a home equity loan, which is simply a loan against a portion of the equity in your home. Instead of taking out a large loan to pay off your current mortgage, you leave your mortgage as is and borrow the amount you need with a smaller loan that is secured by your home equity. The funds are received in a lump sum and repaid on a fixed installment schedule, with terms often ranging from five to 30 years.

Home equity loans are also called second mortgages because they’re second in line to be repaid — after your current first mortgage — if you lose your home to foreclosure.

A home equity loan may make more sense than a cash-out refinance if:

• You need to borrow more than the 80% limit set by most first mortgage cash-out refinance programs
• You want to leave your current, low-interest-rate mortgage alone
• You don’t mind making two monthly mortgage payments
• You have a higher credit score