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Cash-Out Refinance: How It Works and What to Know
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A cash-out refinance allows you to convert home equity into money you can use to improve your finances or your home. You can borrow more than you currently owe on your mortgage and pocket the cash difference to pay off credit cards, spruce up an outdated kitchen or cover a big expense like college tuition or a business venture. A cash-out refinance is a powerful financial tool if you know how it works and understand the pros and cons.
In this article:
- Things to know about a cash-out refinance
- What is a cash-out refinance?
- How does a cash-out refinance work?
- Cash-out refinance requirements
- How much can I get from a cash-out refinance?
- Pros and cons of a cash-out refinance
- How much are cash-out refinance closing costs?
- Rate-and-term vs. cash-out refinance
- Cash-out refinance vs. home equity loan
- Cash-out refinance alternatives
- FAQs about cash-out refinances
Things to know about a cash-out refinance
→ You’ll have to qualify for a higher monthly payment
→ You can use the cash to pay off other debt to reduce your monthly expenses
→ You’ll pay more costs and have a higher interest rate than a rate-and-term refinance
→ You can only deduct mortgage interest on the amount used for home improvements
What is a cash-out refinance?
A cash-out refinance is replacing your current mortgage with a larger loan and taking the cash difference between what you owe and what you borrow. One important thing to remember is you can’t borrow all of your home’s equity, due to limits set by cash-out refinance lenders.
For example, if your home is worth $450,000 and you currently owe $300,000, you have $150,000 of home equity. However, most cash-out refinance programs limit you to borrowing 80% of your home’s value — which means you’d only be able to borrow up to $60,000 of your total $150,000 in equity.
How does a cash-out refinance work?
It takes a little extra legwork to complete a cash-out refinance versus a regular refinance. In most cases, you’ll follow five steps to convert your home’s equity to cash:
- Verify you can afford the loan. Because you’re taking out a larger loan than you currently owe, lenders will vet your income, assets and credit to verify you can make the higher payment.
- Verify how much your home is worth. A home appraisal is generally required to confirm your home’s value. A licensed real estate appraiser compares your home to recent nearby sales with similar features and provides an opinion of value.
- Verify how much you currently owe. A title company requests loan payoff info from your current mortgage company to verify the outstanding balance and provides it to your new lender so they can calculate the principal and interest due at your closing.
- Verify the maximum you can borrow based on the loan program. Standard mortgage programs allow you to borrow up to 80% of your home’s value. This is also called your LTV ratio maximum, which measures how much of your home’s value is being borrowed. However, eligible military borrowers may tap up to 90% of their home’s value with a VA cash-out refi.
- Subtract closing costs and what you owe from your maximum loan amount. With your appraisal in hand, the lender will finalize your total cash out after deducting your current mortgage balance and any closing costs.
Cash-out refinance rates
You’ll typically pay a slightly higher rate for a cash-out refinance than for other loans because lenders consider an equity-tapping refinance riskier than a regular refinance. Why? Because of the risk that home values could drop, leaving you with little to no equity if you need to refinance or sell your home in a financial crunch. There are four factors that affect cash-out refinance rates:
- Your credit scores. Although lenders increase the rates for all credit scores on a cash-out refinances, lower scores have a much bigger impact on how high your rate is. A 740 score will get you the best rate, while a 620 score will result in a significant rate spike.
- Your LTV ratio. The higher your LTV ratio, the more expensive your interest rate will be. Lenders offset this added expense by offering you higher cash-out refinance rates for higher LTV ratio loans.
- Your property type. You’ll pay extra to tap equity from a two- to four-unit property or a condominium.
- Your occupancy. Lenders charge higher cash-out refinance rates for second homes and investment properties.
THINGS TO KNOW
If you recently financed your home you’ll need to wait six to 12 months before you can complete a cash-out refinance. There is an exception for conventional loans if you paid cash for your home and are using the funds exclusively to replenish the cash account used for the purchase.
Cash-out refinance requirements
If you have enough equity to qualify for a cash-out refinance, you’ll also need to meet the cash-out refinance requirements for income, credit and assets set by each program. Lenders will pay close attention to the following five factors when considering whether you can afford a bigger loan.
- Cash-out credit score requirements. You may need to stick with a government-backed FHA loan if your scores are below the 620 cash-out refinance credit score set by conventional lending guidelines. Some lenders may set a higher credit score requirement for their cash-out refinance products.
- Debt-to-income (DTI) ratio. Your DTI ratio is a measure of your total debt divided by your pretax income, and it carries significant weight when you’re borrowing more than you currently owe. The Consumer Financial Protection Bureau (CFPB) recommends a maximum 43% DTI ratio, but lenders may make exceptions if you have high credit scores or extra savings.
- The purpose of your refinance. While lenders don’t restrict what you can do with your cash-out refinance money, they will ask if the extra money is being used to create new debt. For example, if you get a cash-out refinance to buy investment property, the lender will need to document the new mortgage terms to make sure you qualify with the rental home payment.
- The occupancy of the house you’re refinancing. Most borrowers take cash out of their primary residence — that is, the home they live in all the time. However, conventional loans also allow you to borrow money against the equity in an investment property or second home. In most cases, you’ll pay a higher interest rate and be limited to a lower LTV ratio than a primary residence cash-out refinance.
- The number of units in your home. You’ll get the most cash out of a one-unit, single-family home; lower LTV limits apply to two- to four-unit homes.
The table below gives you a glance at the qualifying requirements for different loan types, assuming you’re taking cash out of a single-family primary residence.
|Minimum credit score||620||500||No minimum per VA guidelines|
|Maximum DTI ratio||45% to 50%||43%||41%|
|Maximum cash-out LTV ratio||80%||80%||90%|
How much can I get from a cash-out refinance?
As we mentioned above, in most cases you can borrow up to 80% of your home’s value, although military borrowers have extra cash-out borrowing power. Here’s a brief overview of the most common cash-out refinance programs:
Conventional loans. With guidelines set by Fannie Mae and Freddie Mac, you’ll be able to borrow up to 80% of your home’s value. An added bonus: You won’t pay mortgage insurance, which provides lenders with financial protection if you default on your home loan.
FHA loans. Backed by the Federal Housing Administration (FHA), an FHA cash-out refinance allows you to borrow up to 80% of your home’s value with credit scores as low as 500. The catch: You’ll pay expensive FHA mortgage insurance regardless of how much equity you have.
VA loans. Designed for eligible military borrowers, the U.S. Department of Veterans Affairs (VA) guarantees VA cash-out refinance loans up to 90% of a home’s value. You won’t pay mortgage insurance on a VA cash-out refinance. Instead, the VA charges a funding fee between 2.3% and 3.6% of your loan balance, unless you’re exempt because of a disability related to your military service.
Here’s how the cash-out options would look for a cash-out refinance on a $450,000 home with a 6% mortgage interest rate and a current mortgage balance of $300,000.
|Cash-out refinance program||Maximum base loan amount||Maximum cash back||Monthly payment (principal, interest and mortgage insurance)|
Use a cash-out refinance calculator to get started
If you’re ready to start crunching some cash-out refinance numbers, LendingTree’s cash-out refinance calculator may help. Here’s what you’ll need to get the most accurate figures:
Your home’s value. Try an online home value estimator or give your real estate agent a call to find out about recent sales in your area.
Your current mortgage balance. Check your latest monthly mortgage statement for the most up-to-date info.
Credit score. Your credit score is especially important when it comes to cash-out refinances: A lower score will mean a much higher rate and maybe even discount points.
Cash out. Enter how much cash out you’re looking to borrow from your equity.
Loan-to-value (LTV) ratio. The LTV field is preset to 80% and represents the percentage of your home’s value you can borrow.
Mortgage rate. Input your estimated interest rate. You can also use the online rate tool to get an idea of current rates.
Loan type. Choose a 30- or 15-year loan term.
The calculator will automatically generate your monthly payment with an estimate of your property taxes and homeowners insurance. You can use the “advanced” function button to enter your exact property tax bill and/or insurance premium if you have it handy.
Pros and cons of a cash-out refinance
You can use the cash-out equity for any purpose. Whether it’s consolidating debt or investing in real estate, your home equity can be used as you see fit.
You can expect a lower interest rate compared to other home equity financing options. Mortgage rates are typically lower than credit cards, personal loans or home equity loans, which puts more room in your monthly budget.
Your interest charges may be tax-deductible. If you use your funds for home improvements on a primary residence or second home, you may get a tax break when you file your taxes.
You’ll need at least 20% equity to qualify. If home values have tumbled in your area or you recently purchased with a small down payment, a cash-out refinance may not be possible right now.
You’ll lose some of the equity you’ve built. Borrowing against your home equity now means you’ll make less profit when you sell your home later.
You’ll have a higher monthly mortgage payment. Even if you’re consolidating debt with your cash-out refinance, a higher loan amount means a higher monthly mortgage payment for as long as you own your home.
You may pay a higher rate than other types of refinance. Cash-out refinance rates are typically higher than rate-reduction refinances. If you have a low credit score, you can expect an even higher rate if you’re tapping equity.
How much are cash-out refinance closing costs?
You’ll spend between 2% and 6% of your loan amount on cash-out refinance closing costs. Refinance fees are similar to common fees for a purchase loan and include:
- Application fees
- Appraisal fees
- Credit report fees
- Flood certification fees
- Title search fees
- Title insurance premium fees
There are three ways you can pay your closing costs:
- Pay them out of pocket from your checking or savings account. The lender will need to document your last 60 days of bank statements if you go this route.
- Subtract them from your cash-out funds. The lender will automatically deduct all closing costs from the cash you’re owed.
- Choose a no-cost refinance option. A no-closing-cost refinance trades out-of-pocket closing costs for a higher interest rate and additional interest charges over the life of your loan. The lender simply chooses a rate that pays them enough “extra” to pay the costs on your behalf.
The cash-out refinance closing process
The basic loan process for a cash-out refinance is no different from a purchase loan or regular refinance. In most cases you’ll:
Shop around for the best lender. Some lenders specialize in cash-out refinance loans, so be sure to gather loan estimates from at least three to five mortgage companies within 14 days and lock in the best interest rate as soon as you can.
Provide your financial documents. Most lenders require at least the following to set up your cash-out refinance:
- Current month’s pay stub(s)
- Two years’ worth of W-2s
- Last two months’ bank statements
- A mortgage statement showing your current loan balance
- A copy of your homeowners insurance policy
- Your most recent property tax bill
The lender orders title work and your appraisal. Because you’re paying off a lien attached to your home, you’ll need new title insurance, although you should get a discount on the policy for a refinance. Your home appraisal is even more important on a cash-out refinance — a low value could mean less cash in your pocket.
Finalize your loan figures and review your closing disclosure. Double-check the figures to make sure they’re correct before your signing. If you’re consolidating debt with your cash-out, you’ll need to provide a current payoff statement at your closing.
Rate-and-term vs. cash-out refinance
Many homeowners refinance to save money on their monthly payment or pay off their loan faster. A limited cash-out refinance, or “rate-and-term” refinance as it’s often called, allows you to replace your current mortgage with a new mortgage but limits your cash back to $2,000. The table below shows you when it makes sense to pick a rate-and-term refinance or a cash-out refinance.
|A rate-and-term refinance makes sense if:||A cash out refinance makes sense if:|
|You want to reduce your interest rate||You need extra cash to pay off debt|
|You don’t need extra cash-out||You need extra cash to make home improvements|
|You want to pay off your loan faster||You can afford the higher monthly payment|
|You don’t have enough equity for a cash-out refinance||You’re starting a business or buying an investment property|
Cash-out refinance vs. home equity loan
A cash-out refinance is not the only way to tap your equity; another option is a home equity loan, which is simply a loan against a portion of the equity in your home. Instead of taking out a large loan to pay off your current mortgage, you borrow a smaller loan for the amount of equity you want to use. The funds are received in a lump sum and repaid on a fixed installment schedule, often ranging from five to 15 years.
Home equity loans are also called second mortgages because they’re second in line to be repaid — after your current first mortgage — if you lose your home to foreclosure.
A home equity loan may make more sense than a cash-out refinance if:
- You’re borrowing a small portion of your home equity
- You want to leave your current, low-interest-rate mortgage alone
- You need to borrow more than the 80% limit set by most first mortgage cash-out mortgage programs
- You don’t mind making two monthly mortgage payments
- You have a high enough score for approval than a cash-out refinance requires
Cash-out refinance alternatives
Besides the home equity loan option discussed above, here are a few other alternatives to a cash-out refinance:
- Home equity line of credit (HELOC). A HELOC is another type of second mortgage that initially works like a credit card, except it’s secured by your home. You receive a credit line and only make payments based on how much you borrow, plus interest.
- Fixer-upper loan. If you have big renovation plans, you might consider a conventional renovation option like the Fannie Mae HomeStyle® Renovation loan or an FHA 203(k) rehabilitation loan. One added benefit of fixer-upper loan options: The lender uses the “after-improved” value of your home, which could allow you to borrow more than cash-out refinance guidelines allow.
- Reverse mortgage. Homeowners age 62 years and older with at least 50% equity in their home can convert their equity into cash, a line of credit or monthly income with a reverse mortgage. No monthly mortgage payment is required.
- Personal loan. Unsecured personal loans typically come with a higher rate and shorter repayment term options compared to a cash-out refinance, but your home wouldn’t be used to secure the loan so there’s no foreclosure risk if you default.
- Credit card. While it can help in a time crunch, a credit card should be a last-ditch effort to access the funds you need, since they usually have higher interest rates than the options above.
Cash-out refinances FAQs
It can take several days after your refinance closes to receive your cash. There’s a three-business-day right of rescission on refinance loans, which allows you to cancel the transaction for any reason. If you decide to move forward, your new lender will then pay off your old loan and you’ll receive your cashed-out equity after that point.
Since you’re taking out a new loan to replace your existing mortgage, your credit score and history will be impacted. New credit makes up 10% of your credit score and affects the length of your credit history. This change typically causes a drop in your credit score.
Yes, you can sell your home after going through the cash-out refinance process. However, it’s best to calculate your break-even point before selling. If you decide to sell before you recover your costs, you’ll essentially lose money by refinancing.
Yes, you may qualify for a cash-out refinance on a second home or an investment property, but you won’t be able to borrow as much equity. Lenders limit the LTV ratio for cash-out refis on second homes and investment properties to 75%, meaning you’ll need at least 25% equity after closing.
A cash-out refinance may impact your mortgage interest deduction, which allows you to deduct the loan interest you paid over the year from your taxable income. Unless you use your cashed-out equity to cover a home improvement project on the primary or second home that secures the refinanced loan, you won’t be able to deduct the interest you pay on that portion of your loan. You may still deduct the interest paid on the remaining portion of your loan, though.