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

Published on: April 7, 2022

what is a cash out refinance

If you have enough equity in your house, you can use a cash-out refinance to make a large withdrawal. With a cash-out refinance, you replace your current loan with a new larger mortgage and take the difference between the two in cash. You can use cash-out funds for funding home improvement projects, paying educational expenses, consolidating high-interest debt, or other financial goals.

Since a cash-out refi typically comes with a lower interest rate than credit cards, tapping your home equity in this manner might be a wise move. However, like most loan products, a cash-out refinance also comes with risks if you don’t repay the loan.

What is a cash-out refinance?

A cash-out refinance replaces your current mortgage loan with a larger one. The amount you’re able to borrow is based on how much equity you have in your home — the percentage of your property you actually own. Your equity is calculated by dividing your current mortgage balance by the current value of your home.  

Cash-out refinancing can help you get the cash you need to pay for any expense. Although the funds can be used for any loan purpose, homeowners commonly use cash-out refis to consolidate high-interest debt or fund home improvement projects. The former can help save on interest, while the latter can help increase the value of their homes. 

How does a cash-out refinance work?

When you receive a cash-out refinance loan, a lender gives you the difference between your old and new mortgage loan in cash. It’s different from the typical refinancing process in which you replace your existing loan with a new mortgage for the same amount but with new terms and, ideally, a lower rate.  

To illustrate how the cash-out refinancing process works, let’s say your outstanding mortgage balance is $200,000 and the value of your home is $300,000. After closing on your refinance loan, a lender issues you a new mortgage for $240,000. 

When you close on your new loan, you’ll use $200,000 to pay off the old loan, and the remaining $40,000, minus closing fees, will be yours to use as you wish. 

Use a refinance calculator to see how much your new loan payments would be after doing a cash-out refi.

How much equity can I pull out with a cash-out refi?

The amount of cash you can receive depends on a lender’s maximum loan-to-value (LTV) ratio requirements. This ratio measures the amount of equity you have in your home versus the current value of your home. Although requirements vary, most lenders allow a maximum LTV ratio of 80%, with some accepting a 90% ratio. 

If a lender has a max LTV ratio of 80%, that means you need to maintain at least 20% equity in your home after doing a cash-out refi. In other words, if your home is worth $100,000 and you have 40% equity in your home, you can borrow up to $20,000 in cash. 

However, if you take out a VA cash-out refinance loan, you might be able to borrow up to 100% of your home’s value if you meet certain requirements.  

If you don’t have enough equity in your home to qualify for a cash-out refinance, there are two ways your equity can increase:

  • Pay down your mortgage: When you pay down your mortgage, the equity in your home normally increases. If you want to grow your equity faster, you could make extra payments toward your principal mortgage balance each month. 
  • Your home’s value rises: Your equity will increase if the value of your home increases. This depends on economic factors, such as the real estate market in your area.

Pros and cons of a cash-out refinance

Before using a cash-out refinance, you should consider its advantages and disadvantages. Here are some of the pros and cons to help you decide if a cash-out refi is right for you.  

Pros  Cons 
  • Lower interest rates than other types of loans 
  • Can be used to refinance high-interest debt 
  • Doesn’t change bad spending habits
  • One monthly payment 
  • Can take a long time to receive funds
  • Interest paid may be tax-deductible 
  • Increased risk of losing home

Advantages

  • Lower average interest rates than other financing options: The main advantage of using a cash-out refinance to borrow money is that your new loan will likely have a lower interest rate than a personal loan or credit card. By using the equity in your home to pay for an expense, you can pay less to borrow the money you need.  
  • Can refinance high-interest debt: Using some or all of the cash you receive to refinance high-interest debt can help you get out of debt faster and save on interest. 
  • Single monthly payment: Another advantage of using cash-out refinancing is that you only have to make a single monthly payment. Other ways of tapping your home’s equity require you to take out a second mortgage and make two monthly payments. 

Disadvantages

  • More interest: One of the biggest disadvantages of using a cash-out refinance is that you’ll pay more interest on your mortgage since you’re taking out a larger loan amount and potentially restarting your loan term. Also, you could pay a higher interest rate if the cash-out-refinance rate is higher than the rate on your current mortgage. Be sure to compare the interest rates before using cash-out refinancing. 
  • Closing fees: You’ll likely have to pay closing fees — typically 2% to 5% of your new mortgage. 
  • Slow funding: Since time to close can take up to two months, a cash-out refinance might not be a good option if you need cash immediately. By contrast, a personal loan can be funded as soon as the next business day. 
  • Increased risk of losing your home: Since your home is used as collateral for your new loan, a cash-out refinance may increase your risk of foreclosure if you can’t afford to repay the larger loan amount. 
  • Doesn’t change bad spending habits: Although you can use the cash amount to refinance high-interest debt, this won’t stop you from overspending. If you use it for this purpose, be sure to create a budget to avoid going deeper into debt.

Who should get a cash-out refi?

Whether you should get a cash-out refi depends on your unique financial circumstances. That said, here are some common instances when it could be a good time to refinance: 

  • Home improvement: Using a cash-out refi to fund a home improvement project can increase the value of your property. It’s worth noting, however, that this is the only purpose for cash-out funds that maintains the mortgage interest deduction on the amount you withdraw. Using it for other purposes means you’ll lose that tax benefit. 
  • Consolidating high-interest debt: If the loan you receive has a lower interest rate than your high-interest debt, you can save on interest if you use the cash to eliminate the debt. 
  • Paying for a child’s college expenses: When you can’t qualify for a student loan or the loan interest rate is high, a cash-out refi might be a better option. 
  • Paying medical bills: If you can’t afford to pay a large medical bill, tapping your home equity can be a good option if it helps you avoid taking on high-interest credit card debt. 
  • Paying for an investment property: Using the cash to make a down payment on an investment property can help you expand your real estate portfolio and boost your income.

Alternatives to cash-out refinancing

If you want to avoid changing your loan terms and potentially paying a higher interest rate on your existing mortgage, you should explore some alternative options. Here are some other ways you can borrow against the equity in your home. 

Cash-out refinance vs. HELOCs 

If you’re not sure how much you need to borrow, a home equity line of credit (HELOC) could be a better option. 

Unlike a cash-out refinance, a HELOC operates similarly to a credit card in that it allows you to borrow cash from your home on an as-needed basis. It comes with a draw period that typically lasts 5 to 10 years.  

During the draw period, you withdraw money from your line of credit and some lenders only require you to pay interest. Once the draw period ends, the repayment period begins and you’re responsible for repaying what you borrowed, plus interest. 

Cash-out refinance vs. home equity loans 

With a home equity loan, you access your home equity with a lump-sum payout. The benefit of taking out a home equity loan versus a cash-out refi is that you don’t have to refinance your entire loan.  

This means you can keep the existing rate on your loan and avoid getting a higher rate if mortgage rates have increased.

Cash-out refinance FAQs

Do you pay taxes on the cash portion of a cash-out refinance mortgage? 

When you do a cash-out refi, you don’t have to pay taxes on the amount you withdraw because it’s considered debt and not income. However, there are tax consequences to keep in mind. For instance, to deduct the mortgage interest paid on the cash-out portion, you have to use the funds to “build or substantially improve” your primary or second home. If you use the cash-out funds for other reasons, you won’t be able to deduct the interest paid on the cash-out amount.  

If you qualify, you can deduct mortgage interest paid on the first $750,000 ($375,000 if you file separately while married) of your outstanding mortgage balance. 

How long does it take to close on a cash-out refinance? 

Typically, it takes at least one to two months to close when refinancing your home. The amount of time could be shorter or longer depending on the lender, loan type, and date you close. 

Do you need an appraisal for a cash-out refinance? 

Yes, most lenders will require you to get an appraisal to help determine how much your home is worth and the amount you can withdraw in cash.

To learn more about your home mortgage options, talk to a local Finance of America Mortgage Advisor today.

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