At a Glance

A cash-out refinance can be a smart way to finance expenses like home repairs or to consolidate debt. Unlike other methods of refinancing mortgages, like a home equity loan or home equity line of credit (HELOC), a cash-out refinance won’t add a second mortgage that you’ll need to pay every month. This article will explain:

How does a cash-out refinance work?

A cash-out refinance replaces your current mortgage with a new, larger mortgage. You receive the difference in value between the old mortgage and new mortgage in cash, which you can spend on whatever you’d like. Unlike taking out a second mortgage, you won’t be saddled with an extra monthly payment—you’re just replacing the old mortgage with a new one.

Cash-out refinance example

Let’s say you want to take out $30,000. If you bought your house for $400,000 and have paid off $100,000, you still have $300,000 left of your mortgage. The amount you’ve already paid, $100,000, is your equity stake in your home. With a cash-out refinance, you can take out a portion of your equity in cash.

You’ll take your existing mortgage and add what you’re taking out to calculate the new mortgage. In this case, the new mortgage would be $330,000 (the original mortgage amount plus the $30,000 you’re withdrawing in cash).

When you might need a cash-out refinance

A cash-out refinance can be a good idea if you want to consolidate your debt or renovate your house to raise its value. It could also help you purchase an investment property. It’s not a good idea to use the money for a vacation or new clothes, as you won’t see a return on your investment.

Cash-out refinance requirements

Requirements include:

  • A credit score of at least 580, though 620 is preferred
  • A debt-to-income (DTI) ratio less than 36%. DTI calculates the amount you owe each month by your monthly income
  • At least 36 to 48 months of seasoning on your mortgage. Mortgage seasoning is the amount of time you’ve had your mortgage. The majority of lenders will refuse to offer a cash-out refinance on anything less than 12 months

Cash-out refinance pros

Pros of cash-out refinancing include:

  • Lower interest rate if you originally bought your home when rates were higher
  • Cash-out refinancing can boost your credit score if you use it to pay off high-interest debt such as credit card bills
  • Your mortgage interest may be tax-deductible if used for capital home improvement costs

Cash-out refinance cons

Cons of cash-out refinancing include:

  • Since you’re using your house as collateral, there’s a danger of foreclosure if you’re unable to pay your bills
  • You’ll need to pay closing costs on the new mortgage amount (see below)
  • You might lengthen the amount of time you’ll be in debt due to changing loan terms when you take out your new mortgage
  • You won’t receive the cash right away; you’ll have to go through underwriting, appraisal, and approval processes first, similar to when you bought your home

How much money can I take out?

Lenders limit the amount you can take out up to 80% of your home’s equity. But there are exceptions to this rule.

Loans backed by the Federal Housing Administration (FHA) let you borrow up to 85%, while loans backed by the Department of Veteran Affairs let you take out up to 100% of your home’s value.

What are the fees for cash-out refinancing?

Closing costs will amount to approximately 2-5% of your new loan, depending on the loan size. These costs include appraisal, lender origination, attorney, and credit report fees.

You will also need to pay private mortgage insurance (PMI) if you own less than 20% equity in your home. PMI is eventually cancelled once enough payments are made and equity is gained, but refinancing could result in you having to pay it all over again.

Options other than a cash-out refinance

Other options you can consider include:

  • Home equity loan: A home equity loan also allows you to take out a lump sum of money. However, it is essentially a second mortgage, while a cash-out refinance acts as a brand new mortgage.
  • Home equity line of credit: A home equity line of credit also uses your home as collateral, but unlike a cash-out refinance lump sum, HELOCs provide a line of credit.
  • Personal loan: Personal loans are unsecured loans that usually come with shorter terms compared to mortgages. Interest rates tend to be higher, but since the term durations are shorter you could still save more money with a personal loan than with cash-out refinancing.