
Christina Zerow Lundquist/Getty Images; Illustration: Austin Krege/Bankrate
Important points
-
With a cash-out refinance, your current mortgage is replaced with a new, larger mortgage that converts some of your home equity into cash.
-
The terms of your refinanced mortgage may differ significantly from your original loan, including new interest rates and longer or shorter loan terms.
-
You can do a cash-out refinance for any reason, but most borrowers do it to pay for major home renovations.
Paying off your mortgage can increase the equity in your home, but you don’t have to wait until you pay off the loan in full or sell the property outright to get that equity. Instead, you can use a cash-out refinance to convert your equity into cash and continue paying off your mortgage.
What is a cash-out refinance?
A cash-out refinance is the process of replacing your current mortgage with a new, larger mortgage that includes the balance of your original loan plus cash from the equity in your home. You can receive cash as a lump sum payment. This money can be used for any purpose, including home improvements, debt consolidation, college tuition, and other financial needs.
How does a cash-out refinance work?
A cash-out refinance works similarly to a regular refinance, or an interest rate and term refinance. This means replacing your existing mortgage with a new mortgage with a different interest rate and sometimes a different term. The difference is that you get a new loan for a larger amount rather than the original loan balance. This large amount also includes cash withdrawn from your home equity.
Cash-out refinancing can be beneficial if you can lower the interest rate on your primary mortgage and make better use of the funds you borrowed.
— Greg McBride, CFA, Chief Financial Analyst, Bankrate
How to use the money you get from cash-out refinancing
The money you get from a cash-out refinance can be used for almost any purpose. However, many borrowers use cash-out proceeds for expenses such as:
- Home improvement project: For example, you can use a cash-out refinance to remodel your kitchen or add an addition to your home.
- High interest debt consolidation: Refinance interest rates tend to be lower compared to other forms of debt, such as credit cards. With a cash-out refinance, you can pay off these debts and pay off your loan with one low-cost monthly payment.
- University education: If refinance rates are lower than student loan rates, it makes sense to use your home equity to pay for college.
- investment: Some people use cash-out refinancing to purchase investment properties. Some people use the funds for purposes such as starting a business.
This type of refinancing is a cheaper way to pay off a large expense. One reason for this is that home collateral reduces risk for lenders. For example, when the time comes, you’re much more likely to pay your mortgage than your credit card bill.
How much cash can you get with a cash-out refinance?
If you’re doing a traditional cash-out refinance (the most common type), you can borrow up to 80 percent of the home’s value. However, this threshold varies by property type. For example, apartment complexes are often only up to 75% rentable. With an FHA cash-out refinance, you may also be eligible to borrow up to 80 percent of the home’s value. When you cash out your VA loan, you may be eligible to tap into all of the equity in your home.
Cash-out refinance example
Let’s say you still owe $100,000 on your house, and the house is now worth $400,000. That means you have $300,000 in capital. A cash-out refinance typically requires you to maintain at least 20% equity in your home. In this example, you need to have $80,000 on hand and can take out up to $220,000.
Cash-out refinance requirements
As with your original mortgage, you must meet eligibility criteria to qualify for a cash-out refinance. For conventional loans, these requirements include:
- Credit score: Typically, you need a credit score of at least 620 to qualify. Of course, a higher credit score means a more competitive interest rate.
- Debt-to-income (DTI) ratio: This ratio measures your monthly debt payments, including your newly refinanced mortgage payment, relative to your gross monthly income. Lenders will often cap this at 43%.
- capital: Most lenders require you to have at least 20% equity in your home in order to withdraw cash.
- seasoning: Traditional cash-out REFIs have a six-month seasoning requirement.
Advantages and disadvantages of cash-out refinancing
Strong Points
- You can lower interest rates. This is the most common reason borrowers refinance.
- Borrowing costs may be lower. Cash-out refinances often have lower interest rates than home equity loans, personal loans, and credit cards.
- You can improve your credit score. Using equity to consolidate debt can lower your credit utilization ratio (the amount of your outstanding balance compared to your overall credit limit). This will help increase your credit score.
- Tax deductions are available. You can use the cashed funds for home improvements and deduct the interest when you itemize on your taxes.
Cons
- Interest rates may rise: If the interest rate on your first mortgage increases significantly, your payments on your new loan will increase, even if you have good credit. Since the new mortgage amount is larger, the interest rate will also be higher.
- Repayment may take longer. If you’re using a cash-out refi to consolidate your debt, be careful not to drag out payments for decades that could otherwise be paid off sooner and at a lower total cost. Greg McBride says, “When you borrow cash, the repayments are spread out over 30 years, so paying off high credit card debt with a cash-out refinance may not save you as much as you might think. Please keep in mind that this is a possibility.” Chief Financial Analyst at Bankrate. “A smarter way to spend your cash out is to use it to improve your home.”
- You are at higher risk of losing your home. Refinancing with cash out will increase your mortgage balance. If you are unable to repay your loan, you may be subject to foreclosure and lose your debt. Don’t take out more cash than necessary and try to use it for purposes that improve your finances rather than making your situation worse.
Is a cash-out refinance a good idea for you?
Ultimately, it depends on your needs and personal situation. You may benefit from a cash-out refinance if:
- You need money to improve your long-term financial outlook. If you need to raise a large amount of money to build wealth, such as increasing the value of your home or funding an education, a cash-out refinance can be a good idea.
- You can qualify for a lower rate. You may be able to take advantage of a lower interest rate when refinancing if mortgage rates have gone down since when you first took out your loan, your credit score has improved, or both. If so, a cash-out refinance may make more sense than other ways to leverage your home equity.
Alternatives to cash-out refinance
If a cash-out refinance doesn’t work out for you, there are several alternatives to consider.
- Herock: A home equity line of credit (HELOC) allows you to borrow money when you need it, using a revolving line of credit, similar to a credit card. HELOC interest rates are variable and fluctuate based on the prime rate. To obtain a HELOC you must: requirements.
- Home equity loan: A home equity loan is a second mortgage that provides a lump sum payment. Unlike a HELOC, a home equity loan has a fixed interest rate and you can start repaying it immediately. Bank rates can be used home equity loan calculator Find out how much you might be able to borrow from the equity in your home.
- Personal loan: Personal loans are short-term loans that provide funding for virtually any purpose. Interest rates on personal loans vary widely and depend on your credit score, but the money you borrow is usually repaid in monthly payments, similar to a mortgage. Unlike refinancing, there is often less paperwork involved, and you may be approved and receive financing on the same day you apply.
- Reverse mortgage: A reverse mortgage allows homeowners age 62 and older to withdraw cash from their home. As long as the borrower lives and maintains the home and pays property taxes and homeowners insurance, the balance does not need to be repaid.