Borrowers who refinance their mortgage often want to convert some of their equity in their home into cash. Taking cash out when you refinance can be a good idea, but you should consider your personal financial situation and understand how taking out cash could affect your refinance.
How cash-out refinance works
If you take out cash when you refinance, your new loan will be bigger than the loan you want to replace. The difference between the current pay-off amount and the new balance is paid to you in cash.
Here's an example: Suppose your home is worth $200,000 and you owe $150,000 on your mortgage. You decide to refinance and borrow $160,000, instead of just $150,000. The difference of $10,000 is paid to you in cash. (This simplified example doesn't include closing costs.)
It's important to notice that the larger loan amount will increase the loan-to-value (LTV) ratio on your loan. In this example, the LTV ratio on your existing loan was $150,000/$200,000, or 75 percent, while the LTV ratio on your new loan will be $160,000/$200,000, or 80 percent.
Guidelines for taking out cash
Many lenders will not allow borrowers to take out cash if the LTV ratio on their new loan will be more than 80 percent. That 80 percent is a guideline, not an absolute rule. Some lenders will allow borrowers to take out cash with a higher LTV ratio; however, the requirements likely will be stricter and a higher credit score typically will be required. Lenders' guidelines generally are more flexible for borrowers who don't take out cash.
Caveats to consider
If you take out cash when you refinance, you can use the extra money for any purpose that you want such as to pay medical bills, make improvements to your home or even pay off other debts. But remember that this cash isn't free money. It's a loan against the value of your house just as the balance of your mortgage is.
Remember also that your loan balance and monthly payment will be higher if you take out cash than they otherwise would have been. You should feel confident that you'll be able to afford that higher payment because if you default on your loan, you could lose your home.
If you feel confident that you can afford to borrow against your home equity, you might want to compare a cash-out refinance with a second loan or home-equity line of credit, known as a HELOC. A second loan or HELOC can be a good way to take out cash if you have equity, but don't want to refinance your mortgage.