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Whether you need funds for a new roof, an addition, or to pay off debt, a cash-out refinance is an option homeowners with substantial equity can consider.
Cash-out refinancing can be a great way to tap your home equity when you need money. But before you get too excited about the idea of pulling thousands of dollars out of your house and into your bank account, it’s important to understand the advantages and disadvantages of a cash-out refinance.
In this article:
How does a cash-out refinance work?
While many homeowners opt for a traditional rate-and-term refinance to get a lower mortgage rate or change the length of their loan, a cash-out refinance replaces your current loan with a larger mortgage so you can access your home equity.
Like other mortgage refinancing, cash-out refinancing can be done with a variety of mortgage types. You can refinance a fixed-rate, adjustable-rate, conventional, FHA, or VA loan.
Closing costs, typically 2% to 6% of the loan amount, can be paid in cash or wrapped into the loan balance depending on your lender. However, if you wrap those expenses into your loan, you’ll reduce the amount of cash you can access.
Learn more: How much does it cost to refinance a mortgage?
How much can I cash out?
The amount of cash you can pull out of your house depends on the loan program, your equity, and your borrowing qualifications.
Most conventional and FHA loan programs allow you to borrow a maximum of 80% of the value of your primary home. Conventional loans typically limit you to 70% to 75% if you’re refinancing a second home, an investment property, or a property with more than one unit. In some cases, such as refinancing certain VA loans, you can borrow up to 90% of your home value, including the VA funding fee.
The key to estimating a cash-out refinance is determining your home’s value. For example, if your home is worth $400,000, you can borrow up to $320,000 (80%). If your loan balance is $200,000, you could take as much as $120,000 in cash out of your property. The property value isn’t the amount you paid for the property. Rather, it’s the current market value, typically confirmed by a home appraisal.
Keep reading:
Qualifying for a cash-out refinance
Qualifying for a cash-out refinance is similar to qualifying for any other mortgage. You can shop around with several cash-out refinance lenders to compare loan rates and terms. Lenders review:
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Your credit score. Most require a FICO score of 620 or higher. FHA lenders may be more lenient.
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Your debt-to-income (DTI) ratio. Generally, lenders want the minimum payment on all recurring debt, including the new mortgage payment, to be 45% or less than your gross monthly income.
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Your income. You’ll need to provide pay stubs and a W-2 to verify income.
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Your equity. Most lenders will require an appraisal to verify your home value.
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Your tenure in your home. You’ll usually need to own your property for at least six months to one year before you can apply for a cash-out refinance. Terms can vary depending on your loan type.
Cash-out refinance advantages and disadvantages
There are several pros and cons to consider with any refinance, especially a cash-out refi.
Pros:
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A new rate and term. In the best-case scenario, you can get a lower mortgage rate, but you may also benefit financially by shortening or lengthening your loan term.
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Tax deduction. The interest payments on your mortgage may be tax deductible, but only if you itemize deductions.
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Reducing debt and bills. Eliminating your credit card debt, for example, can improve your cash flow and consolidate the number of bills you’re paying.
Cons:
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Foreclosure risk. If you increase your loan balance and tie all debt to your home, you may increase the possibility of losing your home to foreclosure if you can’t make the payments.
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Higher rate and payments. Your new loan could come with a higher interest rate and higher payments, plus you could end up paying substantially more in interest over the life of the loan.
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Reduced equity. If you sell before paying down your new loan balance or increasing the value of your home, the proceeds of the sale will be reduced.
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Costs. A cash-out refinance requires closing costs.
Learn more: How soon can you refinance a mortgage?
Why consider a cash-out refinance?
If your home has increased in value, you’ve paid down your loan balance for many years, or both, you may have built up a considerable amount of equity in the property. That can leave you feeling house-rich but cash-poor. A cash-out refinance allows you access to cash, but with financial considerations that you must weigh.
You can use the cash from a refinance for anything, but many people choose cash-out refinancing to make home improvements that may increase the value of their home. Other common options include paying college tuition, consolidating debt, or buying investment property.
Read more: How many times can you refinance your mortgage?
Cash-out refinance tips
Before you make any financial move, it’s smart to take a long view of the implications. Before applying for a cash-out refinance, consider:
Before you make any financial move, it’s smart to take a long view of the implications. Before applying for a cash-out refinance, consider:
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The terms. Compare your current loan terms and payments with the new ones to evaluate your comfort level with the new payment.
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Interest costs. Compare the overall interest you’ll pay on each loan. Refinancing a 30-year loan that’s partially paid off to a new 30-year loan with a larger balance may mean you’ll pay thousands more in interest.
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How long you plan to own the home. If you think you may sell in a few years, refinancing may not make sense.
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Alternatives. Consider alternatives such as a home equity loan or line of credit to be certain this is the most financially viable option.
Alternatives to cash-out refinancing
Before you choose a cash-out refinance, you may want to explore other options to access cash, such as:
Home equity loan
Instead of refinancing, a home equity loan allows you to borrow the exact amount you need with a second mortgage with fixed payments. Interest rates for a home equity loan are typically higher than those on a first mortgage, but you’ll be borrowing less since you’re not refinancing your entire loan. In addition, you won’t need to pay substantial closing costs.
A home equity loan could be a sound choice if you want to use a lump sum to achieve a goal. Whether it’s paying off $20,000 in credit card debt or a $50,000 addition to your home, you can use a home equity loan to draw what you need and keep the current rate on your existing mortgage — especially if you’re one of the blessed with a sub-4% interest rate.
Read more: Cash-out refinance vs. home equity loan
Home equity line of credit (HELOC)
A home equity line of credit typically has variable interest rates higher than a first mortgage. Instead of borrowing a lump sum, you’re opening access to credit that you can use as needed. Payments are only due on what you borrow. A HELOC is essentially a credit card guaranteed by your home equity.
A HELOC could be a better idea than refinancing if you plan to use your home equity to fund several small projects over an extended time. From replacing your kitchen appliances today to buying an ATV or covering a college tuition payment tomorrow, a HELOC gives you a renewable credit line that’s ready for the next project when you are.
Learn more: Cash-out refinance vs. HELOC
Personal loan
Personal loan interest rates are typically higher than mortgage or home equity rates because these are unsecured loans. However, a personal loan could make great sense for those with super-low interest rates from the pandemic era.
Instead of refinancing out of your awesome mortgage rate, your great credit could get you a very affordable personal loan for the exact amount you need. With this path, your mortgage stays the same, you save on interest costs, and you get a new loan with a good rate that won’t endanger your home equity.
Credit card
Credit card interest rates are usually higher than most other forms of borrowing. However, there could be certain (albeit limited) circumstances when charging a major expense to a credit card helps you achieve a financial goal.
Say you have an airline miles credit card, and you’re saving up miles for a huge trip. Instead of doing a cash-out refi, you could charge the expense, get the miles and still save on interest — though it’ll take one more step.
After making your purchase, you could transfer that balance to a credit card with an extended term 0% introductory APR. If you can afford to pay off the balance by the end of the introductory period, you’ll score some serious miles while not having to hassle with the time and costs of refinancing.
Cash-out refinance FAQs
Is a cash-out refinance a good idea?
A cash-out refinance could be a good idea if you can refinance to a lower interest rate, find a better loan type, or shorten your repayment term. To qualify, you’ll generally need at least 20% equity in your home and a credit score of 620 or higher. However, some lenders and loan programs have more lenient lending criteria.
Does cash-out refinancing hurt your credit?
A cash-out refinance could temporarily lower your credit score for a few reasons. First, there will be a new hard inquiry on your credit report, which will ding your score a few points. Next, you’ll also be taking on new debt, which increases your total monthly debt obligation and potentially hurts your score. The key to a healthy credit score is a long track record of making on-time payments.
Is it hard to qualify for a cash-out refinance?
Qualifying for a cash-out refinance could be difficult for some borrowers if they don’t meet the credit score and home equity requirements lenders seek. Generally, lenders favor borrowers with at least 20% home equity and credit scores of at least 620. While some loan programs may have more lenient credit and equity requirements, these guidelines are good to know if you’re considering applying for a cash-out refinance.
Laura Grace Tarpley edited this article.
