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How to Use a Cash-Out Refinance for Home Improvements
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Taking cash-out for home improvements is a great way to get tax-free funds at a lower interest rate than other renovation financing options. Home values are up in many parts of the country, which means you may be sitting on equity you can convert to cash to upgrade your kitchen, finish a basement or add a new deck. Knowing how a cash-out refinance works will help you determine if it’s your best choice for financing home improvements.
Cash-out refinancing to renovate: How it works
With a cash-out refinance, you borrow more than you owe up to the limits set by the loan program you choose, pocketing the difference in cash. There are a few extra things you should do if you’re using the cash to fix up your home, however.
Check out these seven steps for getting a cash-out refinance for home improvements:
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- Estimate your renovation costs. Use a remodeling cost calculator to get a rough idea of how much your project(s) will cost. Talk to experts at your local home improvement store or meet with a building contractor if you want exact numbers.
- Determine how much equity you have. Try an online value estimator to ballpark your home’s current value, or ask your real estate agent to prepare a comparative market analysis (CMA) for a more educated guess. Subtract your current mortgage balance from your home value to calculate your home equity.
- Pick the right cash-out loan program. If you have credit scores of 740 or higher and plenty of equity, a conventional loan will typically snag you the lowest rate. Some quick highlights to help you choose:
- Conventional cash-out refinance loans don’t require the mortgage insurance or funding fees charged on government-backed loans.
- An FHA cash-out refinance is insured by the Federal Housing Administration (FHA) and caters to borrowers with credit scores as low as 500.
- Military borrowers can borrow up to 90% of their home’s value with a VA cash-out refinance, guaranteed by the U.S. Department of Veterans Affairs (VA), compared to the 80% cap for conventional and FHA loans.
Check out the cash-out refinance requirements section below for more qualifying details.
- Shop for the best cash-out lender. Check out the rates from three to five different lenders on the same day to make sure you’re comparing apples to apples rate quotes (mortgage rates change daily). Try a rate comparison tool and let lenders call you to compete for your business.
- Gather updated financial documents. Cash-out refinance loans require proof of your income, credit and current mortgage information. Have this information handy so you can fill out an accurate, complete loan application.
- Get your home ready for the appraisal. Most cash-out refinances require a home appraisal, so have your home “show ready” by cleaning the inside, removing clutter and making sure the yard is well-maintained.
- Close your loan and get your cash. Once your appraisal is complete, your lender will send your closing disclosure at least three business days before you sign your paperwork. Double-check the figures to confirm they’re right and sign your documents. If you’re refinancing a primary residence, you’ll get your cash after a three-day waiting period expires — if you’re borrowing against a second home or investment property you can get cash the same day you sign.
How to calculate your maximum cash-out for home improvements
You can use a cash-out refinance calculator to determine how much cash you can get and what your monthly payment will be. If you prefer to do the math yourself, the example below shows the process for calculating the most you could borrow with an FHA cash-out refinance if your home is worth $400,000 and your current mortgage balance is $250,000.
Steps to calculate maximum cash-out for home improvements
THINGS TO KNOW
A home’s loan-to-value (LTV) ratio is measured by dividing the loan balance by the home’s value. LTV limits restrict how much equity you can borrow with a cash-out refinance. In the example above, the homeowner’s total equity is $150,000 ($400,000 home value minus $250,000 loan balance = $150,000 of equity). However, the LTV ratio limit is 80% for an FHA cash-out refinance, which limits the homeowner’s loan amount to $320,000. After subtracting the $250,000 loan balance from the maximum $320,000 loan amount, only $70,000 is available for home improvements.
Pros and cons of a cash-out refinance to renovate
PROS
Your interest rate will be lower than the alternatives. Cash-out refinances usually offer better rates than home equity loans, HELOCs, personal loans, retail home improvement cards or regular credit cards.
Your monthly mortgage payment could go down. If current mortgage rates are much lower than what you’re currently paying, you may end up with a smaller monthly payment even if your loan amount goes up.
You may be able to deduct the interest. Mortgage interest charged on loans used for home improvements is usually tax-deductible.
You can spend your home improvement cash as needed. With a cash-out refinance, you have complete control over how you use the money. Other home improvement loans, like the FHA 203(k) loan, limit how you spend your renovation dollars.
You’ll qualify more easily if you don’t have good credit. Cash-out refinance credit score guidelines are less stringent than they are for home equity loans or home equity lines of credit (HELOC).
You’ll only have one mortgage payment. A cash-out refinance involves taking out one mortgage. A home equity loan or HELOC entails adding a second loan on top of your current mortgage.
CONS
You’ll pay more in long-term interest costs. Financing home improvements over 30 years will add thousands in interest charges over the life of your loan.
Your monthly payment could go up. Because you’re borrowing more than you currently owe to tap extra equity, your monthly payment may go up even if your rate is lower.
You’re borrowing against future profits. If you plan to sell your home in the future, tapping more equity now means you might make less at the closing table later.
Your home’s value may not increase. There’s no guarantee that you’ll recoup home improvement costs, but you can use a cost versus value estimator to get an idea of the resale value of improvements in your area.
You could lose your home. Your home is collateral for a cash-out refinance mortgage for home improvement. If you can’t make your payments, your lender can foreclose on the home.
You’ll pay higher closing costs. Some home renovation loan refinance costs are based on a percentage of your loan amount — so the more you borrow, the higher the closing costs. Expect to pay between 2% to 6% of your loan amount.
Your rate may be higher than a regular refinance. Cash-out refinance rates are typically higher than rates for a rate-and-term refinance.
Cash-out refinance requirements
Use the table below to find a cash-out refinance program that fits your financial situation.
| Cash-out refinance program | Minimum credit score | Maximum loan-to-value (LTV) ratio |
|---|---|---|
| Conventional cash-out refinance | 620 | 80% |
| FHA cash-out refinance | 500 | 80% |
| VA cash-out refinance | No guideline minimum, but 620 is lender standard | 90% |
Alternatives to a cash-out refinance for home improvements
If you don’t have enough equity for a cash-out refinance, consider other types of home improvement loans. And if you don’t like the idea of borrowing against your home, personal loans and home improvement credit cards may be better options.
Home equity loans. You may choose a home equity loan for smaller projects if you want to borrow a lump sum and pay it back with a fixed monthly payment. One caveat: You’ll need a higher credit score to qualify.
Home equity lines of credit (HELOCs). Fixer-upper borrowers like HELOCs because they work a lot like credit cards: You receive a certain amount of credit based on your home’s equity, but only pay back the balance you use, plus interest. In most cases, you can pay off your balance and reuse it as often as you want during the draw period, which usually lasts 10 years. After the draw period ends, you make installment payments to repay the remaining balance.
Renovation loans. You can choose a conventional renovation loan, like the Fannie Mae HomeStyle® Renovation, or opt for the flexible qualifying rules of a FHA 203(k) renovation refinance. Both of these home improvement loans allow you to roll in your remodeling costs even if you have little to no equity in your home. However, you’ll have less control over how you use your funds, since each program requires a contractor and inspector to oversee the project.
Personal loans. You won’t need to use your home as collateral for a personal loan, which means your equity (and your home) are protected. However, you’ll typically have higher interest rates and shorter repayment term options.
Home improvement credit cards. Big-box home improvement stores may offer 0% financing for an introductory time period (such as 12 months), which allows you to avoid accruing interest charges as you pay off your renovation balance. They may be the best way to finance home improvements if you plan to pay off less-expensive projects quickly. Just make sure you keep track of the “interest-free” period to avoid getting stuck with a big deferred interest charge.