Cash-Out Refinance: How It Works and When to Get One

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.

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.

The amount you can borrow depends on your home’s value, mortgage balance, and credit score. You’ll typically need a loan-to-value (LTV) ratio of at least 80% after the cash-out refinance.

For example: Let’s say you bought your house for $250,000 and you’ve paid your mortgage down to $150,000. Your house appreciated in value and is now worth $300,000. Your equity is 50%, or $150,000.

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:

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:

1. Calculate your home equity. Subtract your mortgage balance from your home’s market value.

$300,000 – $150,000 = $150,000

1. 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

1. 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

Our home loan borrowing calculator can help out with that.

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.

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.

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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:

Amy Fontinelle contributed to the reporting for this article.