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What is a cash-out refinance?

Yahoo Personal Finance· Getty Images
Michele Lerner
Updated 6 min read

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.

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.

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 loan or an adjustable-rate loan, a conventional loan, an FHA loan, or a 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.

Dig deeper: How to prepare for a mortgage refinance

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 100% of your home value.

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 home value isn’t the amount you paid for the property, it’s the current market value, which will typically be confirmed by an appraisal.

Learn more: How your loan-to-value ratio affects your mortgage and refinance

Qualifying for a cash-out refinance is similar to qualifying for any other mortgage. You can shop around for a cash-out refinance with several lenders to compare loan rates and terms. Lenders review:

  • Your credit score. Most require a FICO score of 620 or higher. FHA loans and VA loans may be more lenient.

  • Your debt-to-income 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.

  • Your income. You’ll need to provide pay stubs and a W2 to verify income.

  • Your equity. Most lenders will require an appraisal to verify your home value.

  • Your tenure in your home. Depending on the loan program, you’ll need to own your property for at least six months to one year before you can apply for a cash-out refinance.

Dig deeper: How a VA cash-out refinance works

  • 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.

  • Tax deduction. The interest payments on your mortgage may be tax deductible up to certain limits.

  • 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.

Learn more: 15- vs. 30-year mortgage

  • 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.

  • 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.

  • 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.

  • Costs. A cash-out refinance requires closing costs.

Learn more: How a no-closing-cost refinance works

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.

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:

  1. The terms. Compare your current loan terms and payments with the new loan terms to evaluate your comfort level with the new payment.

  2. 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.

  3. How long you plan to own the home. If you think you may sell in a few years, refinancing may not make sense.

  4. Alternatives. Consider alternatives such as a home equity loan or line of credit to be certain this is the most financially viable option.

Before you choose a cash-out refinance, you may want to explore other options to access cash, such as:

Instead of refinancing, a home equity loan allows you to borrow the amount you need with a second mortgage with fixed payments. Interest rates for a home equity loan are typically higher than the rates 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.

Read more: HELOC vs. home equity loan

A home equity line of credit typically has variable interest rates that are 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.

Personal loan interest rates are typically higher than mortgage or home equity rates because these are unsecured loans.

Credit card interest rates are usually higher than most other forms of borrowing.