What is a Cash Out Refinance?
Cash-Out Refinancing 101
With a cash-out refinance, you replace an existing mortgage with a new one that has a higher loan amount. The new, larger loan pays off the old, smaller loan, and the rest goes to you in cash. You can use that cash however you wish.
The new mortgage will have different terms, including a new interest rate, a new loan balance, and a new loan length.
How a Cash-Out Refi Works
The equity you have in your home determines the amount you can borrow for the new mortgage. Most mortgage professionals let you borrow up to 80% of a home’s value.
Take, for example, a home with an appraised value of $300,000 with $100,000 remaining on the mortgage. That means $200,000 in home equity.
To calculate the maximum you can borrow, take 80% of the home’s value, which is $240,000. Subtract what’s still owed ($100,000) to get $140,000. So the owner of that home could probably take out as much as $140,000 in cash.
The approval process works like most other home loans. A mortgage professional will determine if you qualify for a higher loan amount, and there’s usually a home appraisal that the borrower pays for.
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Who can benefit from cash-out refinancing?
Almost anyone with home equity and a plan for cash. Some of the most popular uses include:
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- Home improvements. Using a home’s equity to increase a home’s value is a sound financial strategy. Improvements including stone veneers, kitchen upgrades, and bathroom remodels deliver high returns on investment.
- Debt consolidation. According to recent data from the Federal Reserve, the average incurred interest rate on U.S. credit cards is 22.80%. You could pay off high-interest credit card debt with lower-interest refinancing cash.
- Higher education. The average annual tuition for a public, four-year college can be expensive. Your home’s equity could help you meet tuition needs.
- Investments. The average annual stock market return is about 10%. That’s probably higher than the percentage you would pay on cash borrowed through a refi to buy stocks. From real estate and private equity to cryptocurrency and more, cash-out refinancing could provide seed money to create an extra income stream.
Requirements of Cash-Out Refinancing
Specific requirements vary by mortgage professionals and the borrower’s financial situation. However, borrowers who qualify for cash-out refinancing often have:
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- DTI. A debt-to-income ratio (DTI) of 43% or less is best. This rule of thumb for traditional mortgage approval also applies to getting a new mortgage through cash-out refinancing.
- Credit score. A minimum credit score of 620 is often a threshold for cash-out refinancing approval. As with most financing options, the higher the credit score, the higher the chances of getting a better rate and more attractive terms.
- Home equity. Most mortgage professionals want to see 20% equity in a home. That means you’ve paid off at least 20% of a home’s appraised value.
- Occupancy. With VA loans and FHA loans, the home usually has to be your primary residence and where you have lived for at least a year. Conventional loans often allow cash-out refinancing for second homes and investment properties.
The Pros & Cons of Cash-Out Refinancing
On the pro side
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- Lower interest rate. As with standard refinancing, cash-out refinancing could deliver significant savings if you refinance at a rate lower than your existing mortgage.
- Improved credit score. If you use cash-out financing to pay off your credit card or other personal debt, you will probably boost your credit score.
- Streamlined financing. Cash-out refinancing means one loan with one monthly payment.
Flexibility. It’s your money; you can use the cash you get from cash-out refinancing for anything you wish. - Tax benefits. A portion of the interest you pay on a cash-out refinance could be tax deductible if you use the funds to “buy, build, or substantially improve” a property.
On the con side
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- Fees and closing costs. These are usually between 2% and 6% of the loan amount. You can use a mortgage refinance calculator to estimate your costs.
- Higher payments. Increasing the amount of your mortgage will likely increase the monthly payment amount.
- Overall interest. While it is possible to refinance into a shorter-term mortgage, most borrowers extend their loans, commonly into a new 30-year mortgage. This usually increases the overall interest.
- Equity loss. It may not be a long-term factor, but borrowers looking to sell their homes in the short or medium term could see smaller profits if they reduce the equity they have in their homes.
How to Apply for a Cash-Out Refi
During the application process, most mortgage professionals like to see some or all of this documentation:
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- W-2s for the past two years.
- Pay stubs from the most recent 30-day period.
- The self-employed should have their last two years of tax returns and their most recent profit/loss statements.
- Asset statements, such as those for checking, savings, and retirement accounts.
- Debt statements, such as those for credit cards, mortgages, and auto loans.
- Information on the mortgage you wish to refinance.
Alternatives to Cash-Out Refinancing: HELOCs and HELOANs
Two other ways to borrow against your home’s value include:
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- A home equity line of credit (HELOC) works like a credit card, usually with a higher balance and a lower interest rate. Here, a mortgage professional approves a credit amount a borrower can draw on as needed. The borrower only pays interest on the amount drawn, which they repay in monthly installments.
- With a home equity loan (HELOAN), the borrower gets a one-time lump sum and repays the loan in monthly payments. Unlike cash-out refinancing, which replaces the old mortgage with a new one, HELOANs are separate loans with separate repayment schedules.