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If you own a home, there could be times when you may want to withdraw equity from your home to put it to use elsewhere.

A cash-out refinance (also called a “cash-out mortgage refinance” or a “cash-out refi”) is one way to do just that.

What is cash-out refinancing?

Most of the new loan is typically used to pay off the original mortgage, and the owner can put whatever’s left over in the bank.

You can typically cash out a good portion, but not all, of the equity you’ve built up in your home. As with a traditional mortgage refinance, a cash-out refinance may have a different interest rate and term than your existing mortgage.

How a cash-out mortgage refinance works

Let’s start with an example. A homeowner with a house worth $350,000 has an existing mortgage of $225,000. This means that they’ve built up $125,000 equity in their home.

If they wanted to access some of that equity as cash — say, $50,000 of it — they could gain access through a cash-out refinance. By doing so, the existing mortgage would be paid off and the homeowner would enter into a new loan agreement for a loan worth $275,000.

The homeowner would then receive about $50,000 in cash, minus closing costs and fees imposed by their lender. Fees typically include an application fee, an appraisal fee, title search, and loan origination fee. Costs can range from a few hundred to a few thousand dollars, but sometimes you are able to wrap these costs into the loan amount.

Common reasons for pursuing a cash-out refinance

Though there may be some restrictions to what you can use the cash you receive from your cash-out refinance if you want to be able to deduct the interest you pay on it from your yearly income taxes (more on that below), there is really nothing that you can’t spend the money on.

Some common reasons homeowners pursue a cash-out refinance include:

  • Completing home upgrades or home-improvement projects
  • Paying off other, more expensive, debt like credit cards and auto loans
  • Realizing some equity after a property’s value has increased substantially
  • Funding a 529 college savings plan or paying college tuition
  • Funding a retirement account

How much does a cash-out refinance cost?

Most home buyers take out a 30-year mortgage when they purchase their home because it makes their monthly payments affordable. If you’re refinancing, you may have already been paying your mortgage for a number of years. In this case, many borrowers choose a loan with a shorter term (such as a 15-year loan term when refinancing). When refinancing into a shorter term loan, homeowners often can get a lower interest rate when they refinance.

But if you have a mortgage that you took out when interest rates were near historic lows, you may find that you’d have to pay a higher rate if you refinance. So not only will you be paying interest on the cash you take out of your home — the portion of the mortgage that represents new debt — you’ll also be paying a higher interest rate on the debt you already had. In this case, a mortgage refi may not be the right solution for you.

In short, make sure to compare rates and terms from several lenders. You’ll want to compare the APR for each loan and loan type. The APR includes the points and fees charged by a particular lender in addition to the interest rate. This allows you to make an apple to apples comparison of the different loans.

Requirements

Exact requirements for eligibility will depend on the lender supplying the cash-out refinance, but typically they aim to ensure your creditworthiness as a borrower.

The factors considered often include:

  • Credit Score: Having a “good” credit score of at least 700 can significantly increase your odds of qualifying for a cash-out refinance. Individuals with a credit score of at least 620 may still find approval, though they could potentially face higher interest rates as a result. Being approved with a credit score below 620 could prove challenging.
  • Debt-to-Income Ratio (DTI): Lenders typically look for a debt-to-income ratio that is less than than 45% to 50% (including the new mortgage), though exact requirements vary by lender.
  • Combined Loan-to-Value (CLTV): Your combined loan-to-value ratio (CLTV) is used to determine how much equity you would hold in your home after the cash-out refinance. To find it, divide your desired loan amount (existing mortgage plus desired cash) by the appraised value of your home. Most lenders require borrowers to have a CLTV that is no higher than 75% to 85% (depending on the lender).
  • How long you’ve owned your home: It’s common for lenders to require that you have owned your home for at least one year before you refinance. If you want to refinance before this time period, you might have to pay a prepayment penalty.

Tax Implications

You will not have to pay income taxes on the money you receive through a cash-out refinance, because the money does not count as “income.”

You can claim the mortgage interest deduction for the “home acquisition” portion of your new loan — the amount that you owed on your old loan, plus any proceeds that you use to make improvements to your home — but the rules have changed.

The mortgage interest deduction allows you to deduct the interest you pay on qualified mortgage debt from your taxable income. It used to be that you could claim the mortgage interest deduction on up to $1.1 million in total mortgage debt, including up to $100,000 in home equity debt used for any purpose.

But starting with 2018 tax returns filed in 2019, interest paid on a cash-out refinance or home equity loan is only deductible if used to buy or make “substantial improvements” to your home. Plus, the total limit for newly originated loans is $750,000. So if you’re refinancing more than that, there could be tax implications (always consult with a tax advisor if you have questions).

Alternatives

Cash-out refinancing is not the only tool that homeowners have to access the equity that they have built up in their home. The alternatives below may also achieve that goal, though each carries its own advantages, disadvantages, risks, and tax implications.

Limited cash-out refinancing

A limited cash-out refinance is similar to a cash-out refinance described above in that it grants the homeowner access to some of the equity they have built in their home. Where it differs is in what that money can be used for.

Although money received from a cash-out refinance can generally be used for anything, money received from a limited cash-out refinance is typically limited to being used to:

  • Cover the closing costs and fees of refinancing
  • Pay off a PACE loan or loans taken out for other energy-related home improvements
  • Buy out a co-owner (for example, an ex-spouse or co-heirs)
  • Convert a construction loan
  • Consolidate a first and second mortgage into a new, single loan
  • Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) is a line of credit that allows homeowners to access the equity in their home. It works similarly to a credit card in that the funds are accessed as needed, instead of as a lump sum (though there is often a minimum draw requirement).

The interest rate charged by a HELOC is typically variable, meaning it will ebb and flow along with an index like the prime rate or LIBOR. Like a cash-out refinance, a HELOC involves using your home as collateral.

Home equity loan

A home equity loan typically allows a homeowner to access the equity they have built in their home by taking out a second mortgage. Instead of having a line of credit, you’ll get a one-time, lump-sum payment from a lender.

These loans typically come with a fixed interest rate, allowing you to lock in a set payment amount for the life of the loan. Because a home equity loan is a second mortgage, interest rates may be slightly higher than for a new first mortgage.

The bottom line: choose carefully

Before tapping into their home equity in any way — whether through the use of a cash-out refinance, HELOC, or home equity loan — homeowners must carefully weigh the pros and cons of each option to determine which, if any, is in their best interest.