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Buying a home is one of the biggest investments you’ll ever make – and for many, it demands a large chunk of your cash for the foreseeable future.
That can make it difficult to build your savings and prepare for the inevitable repairs, desired home renovations, and other goals.
If you’re struggling to come up with the funds you need, a cash-out refinance can help you accomplish your goals without relying on credit cards or a second mortgage.
These loans come at lower interest rates than other types of debt, which means you can tap the equity in your home to consolidate other debts, eliminate student loans, and invest for your future at a reasonable price.
What is a Cash-Out Refinance?
As your mortgage matures – in other words, as you pay your monthly bill – you build equity in your home.
Equity is the amount of your home’s value that you own compared to what you owe your mortgage lender.
You can increase your equity by paying down your mortgage and through the natural increase in your home’s value (appreciation).
A cash-out refinance takes advantage of your home equity by refinancing your home for more than the cost of your current mortgage.
The refinance pays off your original mortgage entirely. Then, anything you borrow over the cost of your mortgage is cash in your pocket borrowed from the equity you’ve built – giving you “cash out” of your home.
Let’s look at an example.
Cash-Out Refinance Example
Say that you currently owe $50,000 on a house worth $200,000. You decide to apply for a cash-out refinance of $75,000 so you can get a better interest rate on your remaining mortgage and use the excess funds for some much-needed upgrades. In this instance:
- $50,000 of your new loan pays off your old loan
- The remaining $25,000 goes to you
Of course, it’s still a loan, and you have to pay back the full amount you borrow – so don’t take out too much!
But even on larger loans, a cash-out refinance with the right lender can net you a lower interest rate than your current mortgage, thereby decreasing your long-term obligation.
How Does a Cash-Out Refinance Work?
Taking out a cash-out refinances works similarly to a traditional refinance or your first mortgage.
Once you know that you qualify, the next step is to shop lenders for the best rates and terms. Then, it’s time to:
- Apply to your favorite lenders and pick the best offer
- Proceed with the home appraisal and underwriting process
- Pay any closing costs (or bundle them into your loan)
- And receive your check!
Once you have the money in your pocket, you can use it for just about anything, including paying down debts, covering emergency expenses, and even taking a vacation (though we don’t recommend that last one).
But the smartest move is often to put the money into improving your financial standing, such as home renovations and repairs.
Cash-Out Refinance Requirements
Like a regular mortgage, a cash-out refinance requires that you meet a few criteria before receiving approval.
Most lenders require you to have at least 20% equity in your home based on the current market value before you can take out a cash-out refinance.
To qualify for a cash-out refinance, you typically need a credit score of 620 or higher. If you’re opting for a government-backed refinance, you may be eligible with a credit score as low as 580.
In addition to checking your credit, lenders usually require proof of employment and other income to ensure you make enough to cover the cost of your monthly payments.
Most mortgage lenders won’t approve your loan if you have a debt-to-income ratio over 43%.
That means that your monthly debts (including rent, utilities, and credit card payments) can’t exceed 43% of your gross monthly income. But some lenders accept a DTI as high as 50%.
Lastly, you’ll probably need to get a home appraisal by an independent third party before you can refinance your home.
This can add to your loan costs – but if you’ve benefitted from a good housing market, you may be pleasantly surprised at how much home equity you own!
How Much Can You Get on a Refinance?
The exact amount varies, but lenders typically limit the cash portion of your refinance to 80% of your home’s equity.
For instance, if you owned $100,000 in a home worth $200,000, you’d qualify for an $80,000 loan on top of the value of your mortgage.
That said, if you’re eligible for a VA refinance, you can cash out up to 100% of your home equity.
Some lenders also bend the rules if you have more income, a higher credit score, or meet other parameters.
When Does a Cash-Out Refinance Make Sense?
Cash-out refinances can be a great way to pull cash from your home and better your financial standing – depending on how you use the funds.
#1. Lower Interest Rates
If you can get a lower interest rate than your current loan, a cash-out refinance lets you put some money in your pocket and pay less in the long run. Just be sure that you come out on top after factoring in closing costs (typically 3-5% of your loan).
Additionally, if you’re on an adjustable-rate mortgage (ARM) that just switched from your fixed interest period to variable interest rates, a cash-out refinance lets you lock in a new, fixed rate on a shorter loan term. (Though if you don’t need the cash, a traditional refinance might be wiser.)
And let’s not forget that cash-out refinances often offer lower rates than home equity loans, HELOCs, personal loans, and of course, credit cards. If you need money and don’t want to pay out the nose for it, borrowing against the equity in your home may be the low-cost way to go.
#2. Debt Consolidation
Because of its lower interest rates, the cash leftover from your refinance can let you eliminate high-interest debt in favor of a smaller monthly payment. Over several years, you could save thousands in interest alone, depending on the debt.
#3. Boost Your Credit Score
Using a cash-out refinance to pay down your debts can also build your credit score by reducing your credit utilization ratio, which comprises a whopping 30% of your total credit score.
#4. To Fund Home Projects
Renovations and repairs won’t just make your home cozier – they’ll also increase its value. Assuming that you don’t downgrade your kitchen with questionable design choices.
Anything you do to boost your home’s value, from redoing the bathroom to hiring a professional landscaper, can pump up your profits when you sell.
#5. Tax Deductions
If you use the money from a cash-out refinance to build, buy, or substantially improve your home, you may be able to deduct the mortgage interest on your taxes.
While that alone isn’t a great reason to refinance, it certainly strengthens the case if you’re on the fence!
#6. Frees Up Money to Invest
The wealth-building powers of compound interest only grow over time – and year-over-year, the stock market often averages more returns than your mortgage interest rate (by percentage).
If you take cash out of your home to fund a few smart investments for retirement or college, you can secure your future with comparatively little debt.
Cash-Out Refinance vs. Home Equity Loan
Cash-out refinances, home equity loans, and home equity lines of credit (HELOCs) all let you pull cash out against the equity in your home. However, they’re not quite the same.
For instance, when you take out a home equity loan, your closing costs may be lower, but you’ll usually pay a higher interest rate.
And while refinancing replaces your current mortgage, a home equity loan is an additional loan. Sometimes called a second mortgage.
Home Equity Line of Credit (HELOC) vs. Cash-Out Refinance
A HELOC is a revolving line of credit – essentially a credit card backed by your home. As a revolving credit line, you can pull out cash and repay your debt on a revolving basis.
And, unlike a home equity loan or refinance, you don’t receive a lump sum of cash. Instead, you take out what you need and only pay interest on your withdrawals.
However, your interest rate is typically variable, which can make it difficult to structure monthly mortgage payments.
>> More: Home Equity Loans vs. HELOCs
Disadvantages of a Cash-Out Refinance
While cash-out refinances have their place, they come with plenty of disadvantages, too.
A cash-out refinance is just a loan by another name – and loans come with closing costs. They may include origination fees, appraisal, and attorney fees, among others. Altogether, they can add up to 3-5% of your loan’s total value.
As such, if you only need a small sum of money and your new interest rate won’t be drastically lower, you may reconsider whether a personal loan or HELOC would cost less in the long run.
Private Mortgage Insurance
If you borrow more than 80% of your home’s value, you might find yourself on the hook for private mortgage insurance (PMI), which can add anywhere from 0.5-2.25% of your loan amount each year.
On a mortgage worth $100,000, that comes out to $500-2,250 per year in added costs.
New Loan Terms
Part of the appeal of refinancing your home is scoring a better interest rate than your current loan.
But a new loan means new terms all around – not just your interest rate – and you may find yourself on the hook for larger payments or a few more years of debt.
Any loan that uses your home as collateral puts you at risk of losing your property if you default. In other words, don’t bite off more than you can chew!
Enabling Bad Habits
If you use a cash-out refinance to pay off debts accrued as part of a pattern of poor financial choices (compared to emergencies or a lost job), you aren’t solving the problem – merely shunting it off to address another day.
While refinancing your home to lower your rate or cover high-interest debts is often a good call, taking out cash on top of the loan may be irresponsible if your spending habits run unchecked.
What is the Difference Between Cash-Out and Traditional Refinancing?
With a traditional refinance, you replace your existing mortgage with a new loan of the same size, albeit with new rates and terms.
With a cash-out refinance, you take out a larger loan to pay off your existing mortgage and put a little cash in your pocket.
Note that the two aren’t exactly even – cash-out refinances tend to carry marginally higher interest rates, and a larger loan takes longer to pay off.
That said, if you need a lot of low-interest funding or plan to use the money to improve your financial standing, the price may be worth it.
Bottom Line: What is a Cash-Out Refinance?
A cash-out refinance lets you tap the equity in your home and get a lower interest rate at the same time.
You can use the money to improve your property, secure your future, and set your goals in motion.
But a cash-out refinance isn’t for everyone.
If you don’t need the money, it’s best to let your equity accumulate and opt for a traditional refinance instead.
And if you’re planning to use the funds to pay down a comparatively small sum of high-interest debt – say a couple thousand or so – bear in mind that you’ll pay less interest for 20-30 years, instead of the 5-10 it might otherwise take.