What Is a Cash-Out Refinance and How Does It Work?

What Is a Cash-Out Refinance?

A cash-out refinance is a type of mortgage refinance loan that replaces your existing mortgage with a new one.

Unlike a traditional refinance loan, however, a cash-out refinance loan lets you tap some of your home's equity in the form of a cash disbursement. As a result, the new loan will be larger than the remaining balance on your existing mortgage.

You can use your funds from a cash-out refinance for just about anything you want. Some of the more common reasons include home improvements, debt consolidation and other major expenses.

Learn more >> Should You Tap Into Your Home Equity?

How a Cash-Out Refinance Works

Obtaining a cash-out refinance loan can be a lengthy process that involves a thorough appraisal of your home and your creditworthiness. Here's what the process typically looks like.

1. Determine Your Cash Need

Take some time to evaluate your situation and determine how much cash you need. If you're planning to consolidate debt, this can be as simple as adding up the total amount you owe.

However, if you plan to take money out of your home to finance a home renovation project, you may need to field estimates from contractors to get an idea of how much you need to borrow to cover your expenses.

2. Evaluate Your Mortgage Loan

Gather the details of your existing mortgage loan so you can properly compare cash-out refinance offers from different lenders. In particular, you'll want to know the loan's principal balance, interest rate, monthly payment and the remaining term.

It's important to note that lenders typically only allow you to borrow up to 80% of your home's value with a cash-out refinance. So, you'll also want to get an estimate of your home's current market value to gauge whether you can get enough money to meet your needs.

Websites like Zillow, Redfin and Realtor.com offer free home valuation tools you can use. Just keep in mind that the lender's final decision on what you can borrow will be based on a professional appraisal.

Learn more >> How Much Is My House Worth?

3. Check Your Credit Score

Credit score requirements can vary by lender and loan type. In general, however, you'll want a score of 620 or above to get approved. The higher your score is, the better your odds of securing favorable loan terms.

When you register with Experian, you can get access to your FICO^® Score^☉ and Experian credit report for free. Review your score and report to get a full picture of your credit health. If your score needs some work, consider taking time to get your credit ready before you proceed.

4. Shop Around

When you're ready to move forward, apply with a minimum of three to five mortgage lenders to evaluate your potential terms. In addition to interest rates, you should also compare closing costs, monthly payments and other features that are important to you.

Once you've determined the best offer, compare it to your current mortgage loan to get an idea of whether it's worth it. If market rates are much higher than they were when you took out your loan, for instance, the new monthly payment may be prohibitively expensive.

Consider using this mortgage calculator to run the numbers for each loan and determine whether it's a good idea to move forward.

5. Go Through the Loan Process

If you've determined that a cash-out refinance is right for you, proceed with your chosen lender. You'll need to provide details about yourself and your finances, agree to a home appraisal, and provide any other documentation the lender requires, including:

• W2s or pay stubs
• Bank statements
• Tax statements

Overall, it can take anywhere from 30 to 60 days to complete the process and close on your loan.

How Much Can You Get From a Cash-Out Refinance?

You typically need to have a significant amount of equity in your home to qualify for a cash-out refinance loan. Lenders usually only allow you to borrow up to 80% of your property's value, including both the existing loan balance and the amount you want to take out in the form of cash.

For example, say you have a $250,000 mortgage balance on a home worth $400,000. With a cash-out refinance, you may be able to get up to $70,000 in cash, resulting in a new loan of $320,000.

The actual amount you qualify for can vary depending on the lender, your creditworthiness and other factors.

Learn more >> How to Calculate Home Equity

Cash-Out Refinance Example

Let's say that you bought a home worth $500,000 five years ago with a 20% down payment, a 3.5% interest rate and a monthly payment of $1,796.18 (not including escrow payments).

Now, your loan balance is roughly $358,788 and your home is worth roughly $575,000. In the meantime, you've identified several improvements you want to make to the home, and estimates total around $50,000.

With a maximum loan-to-value ratio (LTV) of 80%, you could potentially get a little more than $100,000 with a cash-out refinance, which is more than enough to meet your needs.

As you compare offers from multiple lenders, you find that the best one gives you a 4% interest rate. Here's what the two loans would look like side by side:

On the flip side, let's say you qualify for a cash-out refinance loan with a 3% interest rate. In this case, your new monthly payment would be $1,723.47, which is lower than your current payment even with the higher loan amount.

Cash-Out Refinance Requirements

A cash-out refinance loan generally comes with the same eligibility criteria as a traditional mortgage refinance loan:

• Equity: The main difference is that you typically need to have more than 20% equity in your home to obtain a cash-out refinance loan—with traditional refinance loans, your LTV may not be a deal-killer unless it's close to 100%.
• Credit: Lenders typically have a minimum credit score of 620. However, they'll also consider your full credit history to make a final decision.
• Debt-to-income ratio (DTI): The sum of your total monthly debt payments should be less than 50% of your gross monthly income.
• Other requirements: Lenders will also consider your income sources, employment history and other factors to determine your eligibility.

Every lender has its own set of credit criteria, so work directly with lenders through the preapproval process to determine your eligibility. While it's possible to get a cash-out refinance with bad credit, there may be additional requirements to mitigate the risk to the lender, as well as higher costs.

Pros and Cons of a Cash-Out Refinance

A cash-out refinance can help you out in a pinch, but there are some important downsides to consider before you pull the trigger and apply. Here are the advantages and disadvantages to keep in mind.

Pros

• Relatively low interest rates: Compared to credit cards and other unsecured loans, you can usually get a lower interest rate with a cash-out refinance. This could allow you to use one to pay off high-interest debt.
• Possible boost in your home's value: If you use your cash to make some improvements to the home, you may be able to increase the value of the property.
• Potential tax benefits: If you use the funds you receive to buy, build or substantially improve your home, you may be able to deduct the interest you pay on the cash portion from your income when you file your tax return every year. Additionally, those improvements will increase your tax basis, which can save you money on capital gains tax when you eventually sell the home.

Cons

• Higher payment: Even if you can secure a lower interest rate than what you're paying now, your monthly payment may end up being higher and could strain your budget. If you struggle with the higher amount, you could risk foreclosure.
• Closing costs: You can expect to pay between 2% and 6% of your new loan amount in closing costs, which can easily amount to several thousand dollars in upfront out-of-pocket expenses.
• Puts your home at risk: Since your home serves as collateral on a mortgage loan, you could be putting your home at risk of foreclosure if you're unable to pay your new loan amount.

Alternatives to a Cash-Out Refinance

Depending on why you're considering a cash-out refinance, you may have several appealing options to save or borrow money. Here are some to consider:

• Personal loan: Personal loans are a versatile form of borrowing you can use to cover a wide variety of expenses. A personal loan can be a good option for debt consolidation, home improvements and other major expenses. They're typically unsecured, so you don't risk losing your home, but interest rates tend to be higher.
• Home equity loan or line of credit: Another way to tap your home's equity at a lower cost is through a home equity loan or a home equity line of credit (HELOC). These are second mortgage loans that you can use to consolidate debt, finance home renovations or pay for other large expenses. Closing costs tend to be lower due to the lower loan amount, but interest rates are usually higher.
• Debt avalanche or snowball method: If you're considering a cash-out refinance to pay down debt, the debt avalanche and snowball approaches can save you money on interest and create more cash in your budget over time. These accelerated repayment strategies can help you pay off your debt more quickly by targeting certain debts and then compounding your payments as you pay them off.

Frequently Asked Questions

• How Can I Use the Money From a Cash-Out Refinance?

  There are no restrictions on how you can use the cash portion of a cash-out refinance loan. However, it's important to carefully consider your reason for borrowing money to determine whether it's worth the cost.

• How Much Are Fees for a Cash-Out Refinance?

  Closing costs can vary by lender, but in general, you can expect to pay between 2% and 6% of the new loan amount.

• Do I Have to Get an Appraisal for a Cash-Out Refinance?

  Lenders require an appraisal for cash-out refinances to determine how much equity you have and, therefore, how much you can borrow.

• Does Applying for a Refinance Affect Your Credit Score?

  You'll typically undergo a hard inquiry when you submit an application, and the lender will likely check your credit again shortly before closing. Additionally, opening a new loan can have a temporary impact on your length of credit history.

• Do You Pay Taxes on a Cash-Out Refinance?

  You won't have to worry about a tax bill on the cash portion of your cash-out refinance loan, primarily because it's considered a loan rather than income.

Get Your Credit in Shape Before Applying

Even if you qualify for a cash-out refinance—or any other financing option—with a relatively low credit score, it may be a good idea to wait until you've had time to work on improving your credit.

Start by checking your credit score and credit report to get an idea of where you stand and which areas you need to address. Then, take the time to work on fixing some of the issues that could prevent you from scoring a lower interest rate and better terms overall.

The process of improving your credit score can take some time, but if your need for cash isn't urgent, taking these steps could ultimately save you more money in interest charges on your new loan.