Chances are you’ve heard that home equity loans and home equity lines of credit (HELOCs) are options for homeowners who want to borrow from home equity. Home equity is the difference between a current mortgage balance and the market value of a home. A borrowing option you may be less familiar with is the cash-out refinance.
A cash-out refinance lets you borrow from your home’s equity in a way that bundles the payment into a new mortgage.
Here, we discuss what it is, how it works, and when it might make sense.
What is a cash-out refinance?
A cash-out refinance is a mortgage refinance where you’re able to borrow money from the transaction. The cash-out refinance works like a typical refinance where a new loan replaces your current mortgage. But there’s one important difference: With a cash-out refinance, the new loan is larger than your old loan and you’re able to take the difference out in cash.
In addition to letting you take cash out of your home equity, a cash-out refinance could also allow you to change the terms of your loan in some way. For instance, you might change your loan repayment term, convert an adjustable-rate mortgage to a fixed-rate mortgage, or refinance to a loan with a lower interest rate.
How does a cash-out refinance work?
When you do a cash-out refinance, your mortgage loan amount increases and you cash out the difference between your new loan amount and the previous loan balance.
Say your existing loan principal balance is $350,000 and you need about $20,000 in cash to do a kitchen remodel. If you meet certain criteria, you could refinance your home loan to $370,000. The first $350,000 would go to paying off your old loan and the remaining $20,000 (minus any refinance-related fees) goes into your pocket.
Whether you can qualify for a cash-out refinance depends on factors such as your credit and how much equity you have built up. We’ll cover the requirements next.
Cash-out refinancing requirements
Lenders will review different criteria to see whether a borrower qualifies for a cash-out refinance. Here’s a general overview of eligibility requirements:
- Credit score: You may need a credit score of 620 or above to qualify for a cash-out refinance loan.
- Debt-to-income ratio: You may need a debt-to-income (DTI) ratio that’s lower than 50%.
- Home equity: In almost all cases, you need to have more than 20% equity in your home to qualify.
How much can you borrow with a cash-out refinance?
Generally, you’re limited to a loan amount that leaves you with 20% equity in the home after the refinance is processed. Lenders generally want you to maintain a loan-to-value ratio, or LTV, of 80% after the cash-out refinance.
LTV is a percentage that represents the value of your home compared with your existing mortgage balance. After refinancing, you must be left with 20% equity, which means your new loan can’t cover more than 80% of the home’s value.
Let’s say your home is worth $400,000 and your loan balance is $260,000 — this means your home equity is sitting at 35%. Here’s a quick look at how we calculated this:
260,000 / 400,000 = 0.65 (or 65%)
100% - 65% = 35% home equity
The additional money you may be able to borrow is $60,000, which would increase your home loan balance to $320,000 and decrease your home equity to the 20% limit. Here’s how we got these numbers:
400,000 * 0.20 (or 20%) = 80,000
400,000 - 80,000 = 320,000
320,000 - 260,000 = 60,000
An exception to this is veteran home loans backed by the U.S. Department of Veterans Affairs. If you qualify for a cash-out refinance VA loan, you can cash out up to 100% of your home equity, depending on your credit score. So if you consider the numbers above, you’d be able to borrow up to $140,000. The higher your score, the more a lender might be willing to approve you for.
When a cash-out refinance might be worthwhile
A cash-out refinance could help you pay for pretty much any expense you need to cover. You could use the cash-out refi to consolidate credit card debt, finance home improvements, or cover medical costs, college tuition, or another major purchase.
Just keep in mind that increasing your loan balance with a cash-out refinance could change your monthly payment and how much you’ll pay in total interest on the loan. If a cash-out refinance increases your monthly mortgage payment and it becomes unmanageable, you could risk losing your house. The interest payments over the life of your loan could also be significantly higher if you extend your loan term.
Before deciding to go with a cash-out refinance, it’s worth figuring out the monthly payment you can afford, reviewing the long-term mortgage interest costs, and comparing refinancing costs against other options, such as a home equity loan or HELOC.
How to get a cash-out refinance
How to get a loan via a cash-out refinance is similar to the process of getting a regular mortgage. Your lender may ask for documents such as pay stubs to review your income and make sure you have enough cash flow to manage the debt. A credit check may also be performed to determine your creditworthiness.
The lender will then order a real estate appraisal to determine how much your home is worth, and your loan will go through an underwriting process before it’s approved. You’ll also be given loan disclosure documents to review and sign.
As with other mortgage refinances, you’ll generally need to pay closing costs — such as credit check fees and appraisal fees. Typical closing costs are between 2% to 5% of the loan amount. If you’re approved, the new loan will pay off the old loan and then you get funds from the cash-out refinance.
If you decide that a cash-out refinance is right for you, then check out our list of the best mortgage lenders.
Alternatives to cash-out refinances
If you want to borrow money, you could also consider other options besides a cash-out refinance. Here are some alternatives:
- Home equity line of credit (HELOC): A HELOC is a credit line that lets you borrow against your home equity up to a limit. Interest rates on HELOCs are typically variable like credit cards, but the credit line aspect offers greater flexibility than a loan because you can use it and pay it back as needed. If you’re doing a project and don’t know exactly how much it’ll cost you, a HELOC could let you draw cash as you purchase materials.
- Home equity loan: The difference between a HELOC vs. home equity loan is that a loan offers a lump sum from your home equity that you pay back in installments. Interest rates are generally fixed on home equity loans, and this could be a good option if you need a set amount to pay a bill.
- Personal loan: A personal loan is another type of installment loan. You can use a personal loan for almost any personal expense, but some lenders restrict you from using personal loans for education expenses. If you have good credit, you might be able to qualify for the best personal loans offering low interest rates and no upfront fees.
Can a cash-out refinance be used for anything?
You can use cash from a cash-out refinance in any way you’d like. Besides paying for home renovations or upgrades with the cash, you could use it to consolidate high-interest debt, as an alternative to student loans, or for another large expense.
Will a cash-out refinance hurt your credit score?
Lenders will likely pull your credit to determine whether you qualify for a cash-out refinance. If a hard inquiry is performed, the credit check could dock your score some points.
Another factor that could hurt your score is that a mortgage refinance is a new account on your report, which could cause an initial credit hit. After establishing a positive payment history on the new loan, your score could improve over time.
Do you pay taxes on a cash-out refinance?
You don’t have to pay tax on the cash you get from a cash-out refinance. The cash is considered a loan, and the IRS generally doesn’t tax loans.
Bottom line on cash-out refinances
When you need money, a cash-out refinance is one of several ways you could turn your home equity into cash. Before borrowing, it’s a good idea to shop around to compare loan options and mortgage rates with multiple lenders. Also, consider weighing other borrowing options — such as home equity loans or HELOCs — to determine which might be best for your personal finance situation.
If you need to borrow a relatively small sum, the closing costs charged and the time it takes to process the new mortgage may make a cash-out refinance less convenient and cost-effective than other options. For instance, personal loans could have lower upfront costs and you may not have to wait out a long underwriting process.