Cash-Out Refinance: Know Your Options
Are you looking for extra cash to make home repairs, pay college tuition, pay off high-interest debt or start a business? If you have equity in your home, you can turn some of that equity you’ve built up into cash with a cash-out refinance.
Now may be a good time to calculate the amount of equity you carry in your home, especially as the housing values have rebounded across most of the U.S. since the 2008 financial crisis.
Before you start the application process for a cash-out refi, it’s essential to understand lender requirements, loan limits, and how you may be putting your home at risk.
What is a cash-out refinance?
A cash-out refinance is a refinancing of an existing mortgage loan, where your new mortgage is for a larger amount than your existing mortgage loan and you get the difference between the two loans in cash. Your new mortgage may have a different interest rate and a shorter or longer term. You may also move from a fixed rate mortgage to an adjustable-rate mortgage or vice versa.
How a cash-out refinance works
With a traditional home refinance, your goal may be to lower your interest rate, switch from an adjustable rate mortgage to a fixed-rate mortgage, get rid of a PMI requirement, or change from a 30-year to a 15-year term. You don’t take any equity out of the home or receive any cash in the process. Your existing loan balance remains the same; you just switch to a loan with different terms.
But with a cash-out refinance, the goal is usually to access your home’s equity. The proceeds from a cash-out refinance are first used to pay off your existing mortgage(s), including any closing costs and prepaid items such as real estate taxes and homeowners’ insurance. The remaining funds are yours to use as you wish.
Bill Rice, a licensed mortgage loan officer and CEO of Velocity Lending in Flat Rock, Mich., says the requirements to get approved for a cash-out refi on your primary residence are:
- A minimum credit score of 620. A qualifying credit score is the middle score of the three primary credit bureaus: Equifax, Experian, and Transunion. That means if your credit score is 700 with Experian, 680 with TransUnion and 660 with Equifax, the lender will use the middle score, 680. Check your credit score estimate at My LendingTree.
- A maximum combined loan-to-value (CLTV) of 80%. Means after your cash-out refinance you must still have 20% equity in your house.
- A maximum debt-to-income ratio of 40-50% (Most lenders stop at 43%). All of your monthly debt obligations, including your new mortgage payment, must be less than 40-50% of your monthly gross income. For example, if your monthly gross income is $5,000 and you have a monthly car payment of $500 and minimum monthly credit card payments of $750, the maximum new mortgage payment after your cash-out refinance would be $1,250. That would have to include your principal and interest payments on your new mortgage as well as homeowners’ insurance and property taxes.
The requirements are much the same if you are seeking to apply for a cash-out refi loan for a second property. The main difference is that the loan-to-value ratio requirement is lowered from 80% to 75%.
To illustrate, let’s say your home is worth $300,000 and your existing mortgage balance is $150,000. You would be able to take up to $90,000 in cash out, with a new mortgage balance of $240,000 ($240,000 ÷ $300,000 = 80%). The first $150,000 of proceeds would be used to pay off your existing mortgage and the remaining $90,000 would come to you in cash.
If the property was instead a second home or investment property, you would be able to take out up to $75,000 in cash out, with a new mortgage balance of $225,000 ($225,000 ÷ $300,000 = 75%).
Rice says the documentation you’ll need to provide for a cash-out refinance will vary based on your circumstances, but it’s generally evidence that you meet the debt-to-income requirements mentioned above.
Typically, this includes:
- Last two years’ worth of income tax returns
- Last two years’ worth of W-2s
- Last two months’ worth of bank statements
- A month’s worth of pay stubs
- The last quarter of investment statements
Your credit score and debt will be verified by a credit report pulled by the lender. The lender will order an appraisal to verify the home’s value. The cost of the appraisal may be rolled into the lender’s application fee, or included in your closing costs.
When does a cash-out refi make the most sense?
A cash-out refinance can be a great way to leverage the significant appreciation in housing values most homeowners have experienced and use that equity to help cover major expenses, like college tuition, debt consolidation, or a home renovation project.
“If you’ve been diligently paying down your mortgage for several years, combined with the increase in home values, you could be sitting on a significant amount of equity in your home,” he says. “By cashing out some of that equity, you can use it to further increase the value of your home or pay off higher interest rate debt like credit cards or personal loans.”
Rice says there are three things you should consider or be prepared for with a cash-out refinance:
- Your monthly mortgage payment may be higher. “Can you afford the higher payment?” he asks. “If you’re paying off higher interest debt, your mortgage payment might go up, but your overall monthly debt payments should go down.”
- Try to keep your loan term the same. While people tend to think of mortgages as either 15- or 30-year loans, Rice says you can, from most lenders, get mortgages at any term increment: “If you had a 30-year fixed-rate mortgage and have been paying on it for seven years, you should be able to get a cash-out refinance and a 23-year fixed-rate mortgage.”
- Any mortgage will have fees and closing costs. “These can be costly if you are continually refinancing your mortgage,” Rice warns. “So think about all of the possible uses of these funds and take the appropriate amount of cash out so you don’t need to refinance year after year.”
Generally, you can use the money you receive from a cash-out refinance for any purpose: to consolidate debt, buy a car, pay for a wedding, finance an education, remodel your home, or even take a vacation. But some reasons for seeking a cash-out refinance may be better than others.
Good reasons for taking a cash-out refinance include:
- Home improvements. The best use of cash-out refinancing may be for home improvements that increase the value of your home. When you use the equity in your home to put money back into your home, you may increase your home’s value, and in turn, create more equity. Just keep in mind that not all home improvements increase your home’s value.
- Buying an investment property. You may be able to use the proceeds from your cash-out refinance to purchase an investment property. With the right property, you can turn your home’s equity into a stream of income.
Risky ways to use a cash-out refinance:
Using a cash-out refinance to consolidate debt can be a controversial strategy. On the one hand, the interest rates for home mortgages are generally significantly lower than the interest rates on credit cards. So by refinancing high-interest credit cards into a home loan, you can reduce your interest rate and your total monthly debt payments.
However, a 2005 report from the Center for Responsible Lending called cash-out refis “equity-draining transactions” and said the benefits of a cash-out refi are often only temporary, “as homeowners build up additional new credit card debt and start the refinance process again.”
Proceed with caution if you plan to use a cash-out refinance to pay off debt or cover personal expenses. It’s generally a bad idea to use your house like a piggy bank, taking out cash for things like vacations or large unnecessary purchases. If you plan on using the proceeds to pay off debt, make sure you don’t rack up additional credit card debt and find yourself facing the same dilemma a few years later.
Remember that when you take equity out of your home, you reduce your interest in the value of the asset. If real estate values fall, you could end up owing more on your home than it’s worth. If you fall into financial troubles and are unable to make your mortgage payment, you could end up losing your home.
Standard vs. limited cash-out refinance
Above, we mentioned generally, the money you receive from a cash-out refinance can be used for any purpose. That’s the case when you do a standard cash-out refi. As the name suggests, with a Limited cash-out refi, your options for using the proceeds are limited.
According to Fannie Mae guidelines, proceeds from a limited cash-out refinance can only be used to:
- Finance the payment of closing costs, points, and prepaid costs associated with refinancing
- Replace a construction loan with a permanent home loan
- Buy out the interest of a co-owner according to an agreement such as a divorce decree
- Replace the first and second mortgage with a single refinance loan.
- Pay off the balance of a PACE loan or other debt used for energy-efficient home improvements.
The borrower can get cash back from a limited cash-out refinance, but the amount they received cannot be more than the lesser of two percent of the new refinance loan amount or $2,000.
|Standard vs. Limited Cash-Out Refinance|
|Standard Cash-out Refinance||Limited Cash-out Refinance|
|LTV of 80% for primary residence or 75% for second/vacation home||LTV of 95.01 to 97%|
|Amount of cash the borrower can receive is limited only by the home’s equity and LTV requirements||Amount of cash the borrower can receive is limited to the lesser of 2% of the new loan amount or $2,000.|
Alternatives to a cash-out refinance
Before you pursue a cash-out refinance, consider and compare the alternatives:
Home equity line of credit
If you don’t need a large lump sum, a home equity line of credit (HELOC) 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.
However, HELOCs are generally adjustable-rate loans, so if interest rates go up, your monthly payment and the cost of borrowing will go up.
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.
Personal loans 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. The interest rate will probably be higher than that of a mortgage, 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.
In addition, personal loans are generally unsecured, so if you face financial troubles and can’t pay the personal loan back, you won’t run the risk of losing your home.
Government loan cash-out refinance options
Several government-backed mortgage programs offer cash-out refinancing and their requirements may be more flexible than conventional loan products.
The FHA loan offers cash-out financing only for owner-occupied principal residences (i.e., not investment properties). To qualify, the borrower must have occupied the home for at least 12 months prior to applying, unless the home was inherited.
FHA cash-back refis are available through FHA-approved lenders. The lender will verify that you’ve made all of the payments on your mortgage within the month the payment was due for the previous 12 months, or since you obtained the mortgage, whichever is less.
The U.S. Department of Veterans Affairs (VA) also offers cash-out refinancing for eligible veteran borrowers.
The maximum LTV for a VA cash-out refinance is 100% of the appraised value, plus the cost of any energy-efficient improvements, plus the VA funding fee. Borrowers can finance the costs of refinancing, included discount points, with the proceeds of the loan.
To qualify, the borrower must certify that he or she intends to occupy the home as a primary residence.
The bottom line
A cash-out refinance can be a good idea if you can lower your interest rate, use the proceeds wisely and you won’t have trouble paying back the new loan. But be careful: any time you use your home as collateral for a loan, you run the risk of losing your home if you run into financial trouble and can’t make your payments.
Before you pursue a cash-out refi, consider the costs and the effect it will have on your monthly debt payments, home equity, and remaining mortgage term.