What Is a Cash-Out Refinance?
A cash-out refinance is a mortgage refinancing option that lets you convert home equity into cash. With a cash-out refinance, you take out a larger mortgage loan, use the proceeds to pay off your existing mortgage and receive the remaining funds as a lump sum. You can use the funds from a cash-out refinance for anything, including debt consolidation or a major purchase.
A cash-out refinance can be an option if you have built up equity in your home from paying down your mortgage or if your home value has increased. The new loan from a cash-out refinance may come with a different interest rate and loan term. However, please use caution since a cash-out refinance increases your monthly payment and mortgage loan balance.
Key Takeaways
- With a cash-out refinance, you take out a new mortgage for more than your previous mortgage balance with the funds used to pay off the old loan and pay you the remainder in cash.
- A cash-out refinance allows you to convert your home's equity into cash for anything, including emergencies, debt consolidation, or a major purchase.
- A mortgage lender determines the approved loan amount by assessing your debt, income, creditworthiness, and loan-to-value (LTV) ratio.
- With a cash-out refinance, you must balance your cash needs with your ability to repay a larger mortgage loan with a higher monthly payment.
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How a Cash-Out Refinance Works
A cash-out refinance allows you to use your home as collateral for a new loan, creating a new mortgage for a larger amount than currently owed. The new mortgage pays off your previous, smaller mortgage balance, and you get paid the difference in cash.
With a standard refinance, the borrower would never see any cash in hand. Typically, refinancingis a popular process for replacing an existing mortgage with a new one that extends more favorable terms to the borrower. Refinancing a mortgage can help you lower your interest rate, decrease your monthly mortgage payments, shorten or extend the loan's term, and remove or add borrowers.
However, a cash-out refinance increases your loan balance and monthly payment since you're withdrawing your home's equity to access cash at the loan's closing.
Determine Your Cash Needs
The funds from a cash-out refinance can be used as the borrower sees fit, but many typically use the money to pay for big expenses such as medical or educational fees, to consolidate debt, or as an emergency fund.
Getting cash by using the equity in your home can be an easy way to get funds for emergencies, expenses, debt consolidation, and purchases. However, it's important to determine your cash needs since borrowing a large amount translates to more debt and a higher payment. With a cash-out refinance, you need to balance the need for cash with your ability to repay a larger mortgage loan.
Find a Lender
Borrowers should seek out a cash-out refinance lender willing to work with them. The lender assesses the current mortgage’s terms, the balance needed to pay off the loan, and the borrower’s credit profile. The lender makes an offer based on an underwriting analysis. The borrower gets a new loan that pays off their previous one and locks them into a new monthly installment plan. The amount above and beyond the mortgage payoff gets paid to the borrower in cash.
Less Equity
A cash-out refinance results in less equity in your home and a larger mortgage loan balance. As a result, the lender is taking on an increased risk, potentially leading to higher closing costs, fees, or interest rate than a standard refinance. Borrowers with specialty mortgages like U.S. Department of Veterans Affairs (VA) loans, including cash-out loans, can often be refinanced through more favorable terms with lower fees and rates than non-VA loans.
Mortgage lenders impose borrowing limits on how much you can borrow through a cash-out refinance—typically 80% of the available equity of your home.
Pros and Cons of a Cash-Out Refinance
A cash-out refinance can offer many benefits to homeowners. However, it's important to evaluate the pros and cons and weigh the benefits of converting equity into cash with the risks associated with taking out a new mortgage loan.
Pros
Lower Interest Rate
The cash-out refinance gives the borrower all of the benefits of a standard refinancing, including a potentially lower rate and other beneficial modifications. Savvy investors watching interest rates over time typically will jump at the chance to refinance when mortgage rates have fallen.
Improve Your Finances and Credit
If the funds from the cash-out refinance are used to pay off credit card debt or personal loans, borrowers can save money on the debt servicing costs due to the mortgage loan's lower interest rate. Also, your finances can improve if the new loan consolidates debt, reducing the number of loan and credit card payments. As a result, you might improve your credit score.
Money for Purchase or Debt Consolidation
Borrowers can use the funds from a cash-out refinance to pay down high-rate debt or fund a large purchase. This option can be particularly beneficial when rates are low or in times of crisis—such as in 2020–21, in the wake of global lockdowns and quarantines, when lower payments and some extra cash may have been very helpful.
Cons
Closing Costs and Fees
There can be a variety of different types of options for refinancing, but in general, most will come with several added costs and fees that make the timing of a mortgage loan refinancing just as important as the decision to refinance.
Higher Debt and Monthly Payments
Consider why you need the cash to ensure that refinancing is your best option. A cash-out refinance may come with a lower interest rate than borrowing via unsecured debt, like credit cards or personal loans. However, you're taking out a larger mortgage loan with higher monthly payments unless you increase the loan's term length. It's important that you have the financial viability to make the payments for many years.
Risk of Losing Your Home
Unlike a credit card or personal loan, with a cash-out refinance, you risk losing your home if you can’t repay the mortgage. Carefully consider whether the cash you withdraw from your home's equity is worth the risk of losing your home if you can’t keep up with payments in the future.
For example, if your home's value decreases, you could end up underwater on your mortgage, meaning you owe more than the house is worth. If you experience job loss or a decrease in income, your new, higher monthly payment might become unaffordable. If you fall behind in your payments and default on the loan, the lender could foreclose on the property in which they repossess the home and resell it.
If you need the cash to pay off consumer debt, take the steps you need to get your spending under control so you don’t get trapped in an endless cycle of debt reloading. The Consumer Financial Protection Bureau (CFPB) has a number of excellent guides to help determine if a refinance is a good choice for you.
Example of a Cash-Out Refinance
Say you took out a $200,000 mortgage to buy a property worth $300,000, and after many years, you still owe $100,000. Assuming the property value has remained at $300,000, you have $200,000 in home equity. If rates have fallen and you are looking to refinance, you could potentially get approved for up to 80% of the equity in your home.
Loan-to-value of 80%
Let’s say your lender will lend you 80% of your home’s value. Your cash-out refinance would have the following financial details:
- New loan: $240,000 ($300,000 home value * .80 loan-to-value)
The loan proceeds would get divided as:
- Take $100,000 and pay off the existing mortgage loan balance
- Receive $140,000 as a lump-sum cash payment
As a result, the new mortgage loan of $240,000 would consist of the $100,000 from the original loan's remaining balance plus the $140,000 you received as cash.
Loan-to-value of 50%
Let’s say that although your lender will lend you 80% of your home’s value, you only want $50,000. Your cash-out refinance would have the following financial details:
- New loan: $150,000 ($300,000 home value * .50 loan-to-value)
The loan proceeds would get divided as:
- Take $100,000 and pay off the existing mortgage loan balance
- Receive $50,000 as a lump-sum cash payment
As a result, the new mortgage loan of $150,000 would consist of the $100,000 from the original loan's remaining balance plus the $50,000 you received as cash.
The disadvantage of the cash-out refinance includes the new lien on your home for the larger mortgage loan balance since it includes the original loan amount and the cash amount. However, you don't need to take on the added risk and higher payments of a mortgage loan at an 80% loan-to-value. You can opt for a lower lump-sum payment, which can help ensure you can repay the loan.
Home equity loans and home equity lines of credit (HELOCs) are alternatives to cash-out or no cash-out (or rate-and-term) mortgage refinancing.
Rate-and-Term vs. Cash-Out Refinance
Borrowers have a variety of options when it comes to refinancing. The most basic mortgage loan refinance is rate-and-term refinance, also called no cash-out refinancing. With this type, you are attempting to attain a lower interest rate or adjust the term of your loan, but nothing else changes on your mortgage.
For example, if your property was purchased years ago when rates were higher, you might find it advantageous to refinance to take advantage of lower interest rates. In addition, variables may have changed in your life,allowing you to handle a 15-year mortgage, saving on the loan's total interest but forgoing the lower monthly payments of your 30-year mortgage. In other words, with a rate-and-term refinance, nothing else changes, just the rate and term.
Cash-out refinancing has a different goal. You receive the difference between the two loans in tax-free cash. This is possible because you only owe the lending institution the original mortgage amount. Any extraneous loan amount from the refinanced, cash-out mortgage is paid to you in cash atclosing, which is generally 45 to 60 days from when you apply.
Compared to rate-and-term, cash-out loans usually come withhigher interest rates and other costs, such aspoints. Cash-out loans are more complex than a rate-and-term and usually face more extensive underwriting standards. A high credit score and a lower relativeloan-to-value (LTV) ratiocan mitigate some concerns and help you get a more favorable deal.
Cash-Out Refinance vs. Home Equity Loan
With a cash-out refinance, you pay off your current mortgage and enter into a new one. With a home equity loan, you are taking out a second mortgage in addition to your original one, meaning you now have twolienson your property. This could translate to having two separate creditors, each with a possible claim on your home.
Closing costs on a home equity loan are generally less than those for a cash-out refinance. If you need a substantial sum for a specific purpose, home equity credit can be advantageous. However, if you can get a lower interest rate with a cash-out refinance—and if you plan to stay in your home for the long term—then the refinance might make sense. In both cases, make sure you can repay the new, higher loan amount because otherwise, you could lose your home if you default on the payments.
Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
What Is Home Equity?
Home equity is the market value of your home minus any liens, such as the amount you owe on a mortgage or a home equity loan. The equity in your home can fluctuate based on real estate market conditions in the community or region where you live.
How Do I Calculate Home Equity?
To calculate the equity in your home, simply subtract the mortgage balance owed from the market value of the property. For example, if your home is valued at $600,000 and you owe $200,000, then you have $400,000 in home equity.
How Can I Use the Money From a Cash-Out Refinance?
There are no restrictions on how you can use the funds from a cash-out refinance. Many borrowers use the cash to pay for a big expense, such as to fund an education, pay down debt, or as an emergency fund.
The Bottom Line
Refinancing is a means of replacing an existing mortgage with a new one that presumably has better terms for the borrower. On the other hand, a cash-out refinance allows the borrower to convert home equity into cash.With a cash-out refinance, the borrower takes out a new mortgage for more than the previous loan, uses the funds to repay the old loan, and receives a lump sum cash payment for the remaining funds. As a result, a cash-out refinance increases your monthly payment and mortgage loan debt—please consider carefully.
