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

Key takeaways

→  You’ll need to have enough home equity to tap and (in most cases) the ability to qualify for a higher monthly payment
→  You’ll pay more in closing costs and have a higher interest rate than if you simply refinanced without taking any cash out
→  You can use the cash to pay off other debt, reduce your monthly expenses or meet another financial goal

What is a cash-out refinance?

A cash-out refinance is when you take out a new mortgage that’ll pay off your existing home loan and leave you with a significant amount of money. The difference between what you owe on your old loan and what you borrow is yours to take as a lump sum in cash. Two important things to remember: 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. Make sure 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 you could come out with lower mortgage payments if interest rates have significantly dropped since your first loan.

2. Find out how much your home is worth

A home appraisal is often required and has been the standard way to evaluate your home’s value for many years. With an appraisal, a real estate appraiser compares your home to recently sold homes in your area with similar features and provides an opinion of value. However, as of April 15, 2023, you may have other options to determine your home’s value, including:

• Value acceptance. Formerly known as an “appraisal waiver,” this option is when the lender-provided home value is accepted without the need to confirm it with an appraisal.
• Value acceptance plus property data. This option skips the need for an appraisal and appraiser, but still depends on property data collected by a third-party professional who is trained to assess the home.
• Hybrid appraisal. A hybrid appraisal is a method of property valuation that involves collaboration between an appraiser and a property-data collector.

3. Find out how much 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. Pick the best lender for your cash-out refinance

Taking the time to compare rates from three to five lenders can save you thousands of dollars in the long run. LendingTree’s list of the best mortgage refinance companies includes several lenders who offer cash-out refinances.

5. Find out how much cash you can take out

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:

Minimum 620 credit score

Conventional loan guidelines require a minimum 620 credit score 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.

Maximum 43% debt-to-income (DTI) ratio

Your DTI ratio is a measure of your total monthly 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.

Occupancy

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 maximum.

Number of units 

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.

The type of home

You might face extra fees at closing or higher interest rates if the home you’re borrowing against is a condo or manufactured home.

Waiting period

If you recently financed your home, you’ll need to wait six to 12 months before you can complete a cash-out refinance. There’s an exception for conventional loans if you acquired the home through inheritance, divorce or were otherwise awarded the house in a legal proceeding.

Cash-out refinance rates: Factors that affect rates

You’ll typically pay a slightly higher rate for a cash-out refinance than for other loans, as lenders consider an equity-tapping refinance riskier than a regular refinance.

There are six main factors that affect what cash-out refinance rates you’ll be offered:

→  Your loan type. As of May 1, 2023, conventional cash-out refinance borrowers will pay a fee for taking cash out of their home. The fee will range from 0.375% to 5.125% of the total loan amount.

→  Your credit scores. Although lenders increase the rates for everyone on cash-out refinances, your credit score will also have a big impact on how high your rate is. In recent years, conventional borrowers with a credit score of 740 or higher got the best rates, but come May 2023, you’ll need a 780 or higher to get the best rate.

→  Your LTV ratio. The higher your LTV ratio, or the percentage of your property’s value you borrow, the more risky your loan is considered to be and therefore the more expensive your interest rate will be. While in the past the fees charged to conventional loan borrowers with the highest LTVs amounted to 2.125% of the total loan amount, as of May 2023, the maximum fee will increase to 5.125% of the loan amount.

→  Your DTI ratio. Conventional borrowers with DTI ratios over 40% will pay either an extra fee at closing or an increased interest rate if they’re borrowing more than 60% of their home’s value.

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

→  Your occupancy. Lenders may 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 $300,000 mortgage balance:

Use a cash-out refinance calculator

If you’re ready to start crunching some numbers, LendingTree’s cash-out refinance calculator can help. It’ll automatically generate your monthly payment and LTV ratio, as well as warn you when you’ve gone above the amount of cash you’re likely to access using a refi.

Cash out refinance closing costs

You can expect to spend between 2% and 6% of your loan amount on cash-out refinance closing costs. Most refinance fees are similar to common fees for a purchase loan and you can pay them out of pocket, subtract them from your cash-out funds or choose a no-closing-cost refinance option.

Is a cash-out refinance a good idea?

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 used a small down payment for a recent home purchase, 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.

When is it a good idea to get a cash-out refinance?

The best time to get a cash-out refinance is when interest rates are lower than the interest rate you have on your current mortgage. That said, interest rates in early 2023 remain high — so you’re not likely to be able to jump into a new loan with a lower rate unless your credit has improved significantly since you bought your home and your mortgage rate was already high.

It could still pay to get a cash-out refinance, if:

• You’re going to take on more debt no matter what. The interest rates on a personal loan, credit card or home equity loan will be higher than a cash-out refi. If you’re going to take on debt, it’s always smart to choose the least expensive way to borrow. Some things in life — college, emergencies, wheelchair ramps — won’t wait.
• You’ll use the funds to build equity. If you do home renovations that boost your home’s value, you’re using the money to make more money — a move that can really pay off later.
• You want to consolidate debt. With credit cards charging a mind-boggling average interest rate of 23.55%, it could make a lot of sense to use a cash-out refinance to dodge the bullet and take shelter in the land of single-digit rates.