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When you own a home, you build equity over time by making payments toward the principal and letting the market value naturally appreciate. The downside? Your equity is typically locked up until you sell the property.
However, you can tap into your home equity without having to move. A cash-out refinance replaces your old mortgage with a new, larger loan. You pocket the difference and pay down the new loan over time.
While there are many benefits to getting a cash-out refinance, it isn’t always the best way to access your home equity.
Here’s what you need to know about cash-out refinances, including some of the major pros and cons:
- What is a cash-out refinance?
- How does a cash-out refinance work?
- Pros and cons of cash-out refinancing
- Calculating how much you can borrow
- Cash-out refinance rates
- What are the eligibility requirements for a cash-out refinance?
- 5 steps to get a cash-out refinance
- Cash-out refinance vs. home equity loan
- More alternatives to cash-out refinance
What is a cash-out refinance?
A cash-out refinance is a type of mortgage refinance that allows you to take out a loan for more than you owe on your current mortgage. The lender hands you the difference in cash, minus closing costs. You pay back the new loan over time, usually between 15 and 30 years. Your home acts as collateral on the loan, just like with a regular mortgage.
How does a cash-out refinance work?
A cash-out refinance replaces your existing mortgage with a new, larger mortgage. You get the difference as a lump sum of cash, usually through a wire transfer to your bank account after closing. You can use the cash for any purpose, but popular uses include debt consolidation and home improvements.
There’s usually a “seasoning” requirement, which is a period you’ll need to wait between closing on your first mortgage and getting a cash-out refinance. The seasoning requirement depends on the type of mortgage you have.
- Conventional loans: You’ll need to own the home for at least six months.
- VA loans: You’ll need to wait at least 210 days from the first payment or make at least six payments on the loan, whichever is longer.
- FHA loans: You’ll need to live in the home for at least 12 months before applying for a cash-out refinance.
Lenders generally only allow you to borrow against 80% of your home’s value, so, in this case, you’ll be able to get a new loan for $240,000 and cash out $90,000.
That maximum loan amount will also need to cover closing costs, like administrative expenses and appraisal fees.
Pros and cons of cash-out refinancing
A cash-out refinance allows you to borrow a potentially large amount of money, usually at a lower interest rate than unsecured loans. But you’ll drain your equity in the process, and you may be at a higher risk of foreclosure if you can’t afford your increased monthly payments.
Before pursuing a cash-out refinance, consider the following benefits and drawbacks:
|Pros of cash-out refinancing
|Cons of cash-out refinancing
|Lower interest rates: If interest rates have decreased since you took out your first mortgage, cash-out refinancing may help you secure a lower rate.
|Higher interest costs: These loans often have slightly higher interest rates compared to standard rate and term refinances. Additionally, borrowing more money and extending your loan term can increase the amount of interest you pay over the life of your loan.
|Large loans: You may be able to borrow more than you could with a personal loan or credit card. Since the cash-out loan is secured by a valuable asset — your home — mortgage lenders are typically generous with borrowing limits.
|Closing costs: These typically range from 2% to 5% of the loan amount. You may be able to avoid closing costs or even get a credit at closing, but you’ll probably pay a higher interest rate in exchange for the upfront savings.
|Potential tax benefits: Interest payments on home loans are tax-deductible when you use the money to buy, build, or substantially improve your home.
|Foreclosure risk: If your new loan increases your monthly payment, you might have a harder time keeping up if your income dips or your expenses rise. You could be at higher risk of foreclosure than if you hadn’t refinanced.
|Manage just one loan: You’ll deal with just one payment each month, whereas other forms of borrowing require you to make separate payments on your debt.
|Lost equity: Cash-out refinancing reduces your home equity. That could put you at greater risk of ending up underwater on your loan and being unable to pay it off should home values drop and you need to sell.
If you’re considering a cash-out refinance, be sure to look at as many lenders as possible. Credible makes finding the best deal easy — you can compare multiple lenders and see prequalified refinance rates in as little as three minutes.
Calculating how much you can borrow
To find out how much you can borrow with a cash-out refinance, start by checking your home’s market value and your mortgage balance. Lenders usually require you to have at least 20% equity in your home after closing on the cash-out refinance, which limits how much you can borrow.
Here’s a step-by-step guide for crunching the numbers:
- Calculate your home equity. Subtract your mortgage balance from your home’s market value.
$300,000 – $150,000 = $150,000
- Find your mortgage balance. Multiply your home’s value by your maximum LTV ratio. Keep in mind that most lenders will only allow you to borrow against 80% of your home’s value.
$300,000 x 0.80 = $240,000
- Figure out how much cash you’ll receive. Subtract your current mortgage balance from the maximum mortgage balance allowed by your lender.
$240,000 – $150,000 = $90,000
What are the eligibility requirements for a cash-out refinance?
To get a cash-out refinance, lenders usually require:
- Home equity of at least 20%
- An LTV ratio of no more than 80%
- A current appraisal of your home to verify its value
- A credit score of at least 620
- A debt-to-income ratio (including the new loan) of 43% or less
- Verification of your income and employment
- Meet the seasoning requirements based on the type of loan you have
Cash-out refinance rates
Today’s cash-out refinance rates are still near historic lows. However, these rates can be as much as 0.5% higher than a traditional mortgage refinance since you’re tapping your home equity.
Several factors impact your cash-out refi rate, such as:
- Credit score: A higher credit score can help you qualify for a lower mortgage rate.
- Loan-to-value ratio (LTV): A lower LTV ratio can reduce your rate if you don’t access all of your available home equity since you’re borrowing less.
- Repayment term: Longer repayment lengths have a higher interest rate but a lower monthly payment.
- Closing costs: Your lender may allow you to roll your closing costs into the loan. Unfortunately, this choice increases your APR and total amortization.
- Debt-to-income ratio (DTI): A higher DTI poses more risk and a lender may not approve your application. Strive to have a DTI ratio of 36% or less before you apply with a conventional mortgage lender.
With a cash-out refinance, you’ll pay the same interest rate on your existing mortgage principal and the lump-sum equity payment. Most lenders offer fixed interest rates so you can easily calculate your monthly payment.
5 steps to get a cash-out refinance
The steps to getting a cash-out refinance are similar to the process of getting your first mortgage. You’ll check the lender’s requirements, determine how much you want to borrow, and apply with the lender you choose.
- Compare lenders. Every lender has its own way of setting borrowing requirements, interest rates, and closing fees, so it’s a good idea to shop around. Compare offers from at least three lenders before making your choice.
- Check your lender’s eligibility requirements. Ask about the minimum credit score, maximum debt-to-income ratio, and maximum LTV ratio to see if you’re eligible for a cash-out refinance.
- Determine how much cash you want to borrow. Your lender may approve you for a certain amount, but you don’t have to borrow the max. Consider how much you need based on how you’ll use the funds.
- Fill out the application and go through underwriting. Once you’ve chosen a lender, fill out the loan application and submit your supporting documents. The lender will review these materials and order a home appraisal.
- Close on the loan. On closing day, you’ll sign the loan documents and get a check for the “cash out” portion of your loan.
The best way to know how much a cash-out refinance would cost you is to get quotes from multiple lenders. You can get prequalified offers from Credible in just a few minutes — checking rates with us is free and won’t impact your credit score.
Cash-out refinance vs. home equity loan
A cash-out refinance and a home equity loan are two different ways to access your home equity with a fixed interest rate.
As previously discussed, cash-out refinancing lets you take out a new mortgage that’s worth more than your existing mortgage and receive the difference in cash. You might consider this option if you want to reduce your interest rate or change your repayment terms.
Home equity loans are second mortgages and, as such, don’t modify your existing mortgage. While there are more restrictions regarding how you can use your equity, this option can be better if you don’t want a new interest rate or repayment terms.
More alternatives to cash-out refinance
If you’re not sure a cash-out refinance is right for you, consider these alternatives:
|Rate-and- term refinance
|Home equity loan
|A home loan that replaces your old mortgage, with updated terms
|Lump-sum second mortgage secured by your home
|Revolving line of credit secured by your home
|Unsecured loan provided as a lump sum
|Borrower gives equity to the lender in exchange for lump-sum or monthly payments
|Fixed or variable
|10 to 30 years
|10 to 15 years
|10-year draw period, 20-year repayment period
|1 to 7 years
|No set term
|You don’t need cash, but you want to change your home loan’s interest rate, loan term, or both
|You have a large one-time expense
|You’re not sure how much money you’ll need to borrow, or when
|You have a one-time expense but don’t want to risk your collateral
|You want to supplement retirement income
Amy Fontinelle contributed to the reporting for this article.