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If you’re cash poor and home equity rich, a cash-out refinance could be the ticket to funding home improvements, consolidating debt, or helping with any other need. With this type of refinancing, you take out a new mortgage for a larger amount than what you have left on your current mortgage and receive the excess amount as cash.

However, getting a mortgage with a cash-out isn’t always the best route to take when you need extra money. Read on for a closer look at this form of home refinancing, including how it works, how much cash you can get, its pros and cons, and alternatives to consider.

What Is a Cash-Out Refinance?

A cash-out refinance involves taking out a new mortgage loan that will allow you to pay off your old mortgage plus receive a lump sum of cash.

Like other types of refinancing, you end up with a new mortgage which may have different rates and a longer or shorter term, as well as a new payment amortization schedule (which shows your monthly payments for the life of the loan).

The cash amount you can get is based on your home equity, or how much your home is worth compared to how much you owe. You can use the cash you receive for virtually any purpose, such as home remodeling, consolidating high-interest debt, or other financial needs.

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How Does a Cash-Out Refinance Work?

Just like a traditional refinance, a cash-out refinance involves replacing your existing loan with a new one, ideally with a lower interest rate, shorter term, or both.

The difference is that with a cash-out refinance, you also withdraw a portion of your home’s equity in a lump sum. The lender adds that amount to the outstanding balance on your current mortgage to determine your new loan balance.

Refinancing with a cash-out typically requires a home appraisal, which will determine your home’s current market value. Often lenders will allow you to borrow up to 80% of your home’s value, including both the existing loan balance and the amount you want to take out in the form of cash.

However, there are exceptions. Cash-out refinance loans backed by the Federal Housing Administration (FHA) may allow you to borrow as much as 85% of the value of your home, while those guaranteed by the U.S. Department of Veterans Affairs (VA) may let you borrow up to 100% of your home’s value.

Cash-out refinances typically come with closing costs, which can be 2% to 6% of the loan amount. If you don’t finance these costs with the new loan, you’ll need to subtract these costs from the cash you end up with.

💡 Quick tip: Using the money you get from a cash-out refi for a home renovation can help rebuild the equity you’re taking out. Plus, you may be able to deduct the additional interest payments on your taxes.

Example of Cash-Out Refinancing

Let’s say your mortgage balance is $100,000 and your home is currently worth $300,000. This means you have $200,000 in home equity.

If you decide to get a cash-out refinance, the lender may give you 80% of the value of your home, which would be a total mortgage amount of $240,000 ($300,000 x 0.80).

From that $240,000 loan, you’ll have to pay off what you still owe on your home ($100,000), that leaves you with $140,000 (minus closing costs) you could potentially get as an get as cash. The actual amount you qualify for can vary depending on the lender, your creditworthiness, and other factors.

Common Uses of Cash-Out Refinancing

People use a cash-out refinance for a variety of purposes. These include:

•   A home improvement project (such as a kitchen remodel, a replacement HVAC system, or a new patio deck

•   Adding an accessory dwelling unit (ADU) to your property

•   Consolidating and paying off high-interest credit card debt

•   Buying a vacation home

•   Emergency expenses, such as an unexpected hospital stay or unplanned car repairs

•   Education expenses, such as college tuition

Qualifying for a Cash-Out Refinance

Here’s a look at some of the typical criteria to qualify for a cash-out refinance.

•  Credit score Lenders typically require a minimum score of 620 for a cash-out refinance.

•  DTI ratio Lenders will likely also consider your debt-to-income (DTI) ratio — which compares your monthly debt payments to monthly gross monthly income — to gauge whether you can take on additional debt. For a cash-out refinance, many lenders require a DTI no higher than 43%.

•  Sufficient equity You typically need to be able to maintain at least 20% percent equity after the cash-out refinance. This cushion also benefits you as a borrower — if the market changes and your home loses value, you don’t want to end up underwater on your mortgage.

•  Length of ownership You typically need to have owned your home for at least six months to get a cash-out refinance.

Tax Considerations

The money you get from your cash-out refinance is not considered taxable income. Also, If you use the funds you receive to buy, build, or substantially improve your home, you may be able to deduct the interest you pay on the cash portion from your income when you file your tax return every year (if you itemize deductions). If you use the funds from a cash-out refinance for other purposes, such as paying off high-interest credit card debt or covering the cost of college tuition, however, the interest paid on the cash-out portion of your new loan isn’t deductible. However, the existing mortgage balance is (up to certain limits). You’ll want to check with a tax professional for details on how a cash-out refi may impact your taxes.

Cash-Out Refi vs Home Equity Loan or HELOC

If you’re looking to access a lump sum of cash to consolidate debt or to cover a large expense, a cash-out refinance isn’t your only option. Here are some others you may want to consider.

Home Equity Line of Credit

A home equity line of credit (HELOC) is a revolving line of credit that works in a similar way to a credit card — you borrow what you need when you need it and only pay interest on what you borrow. Because a HELOC is secured by the equity you have in your home, however, it usually offers a higher credit limit and lower interest rate than a credit card.

HELOCs generally have a variable interest rate and an initial draw period, which can last as long as 10 years. During that time, you make interest-only payments. After the draw period ends, the credit line closes and payments with principal and interest begin. Keep in mind that HELOC payments are in addition to your current mortgage (if you have one), since the HELOC doesn’t replace your mortgage.

Home Equity Loan

A home equity loan allows you to borrow a lump sum of money at a fixed interest rate you then repay by making fixed payments over a set term, often five to 30 years. Interest rates tend to be higher than for a cash-out refinance.

As with a HELOC, taking out a home equity loan means you will be making two monthly home loan payments: one for your original mortgage and one for your new equity loan. A cash-out refinance, on the other hand, replaces your existing mortgage with a new one, resetting your mortgage term in the process.

Personal Loan

A personal loan provides you with a lump sum of money, which you can use for virtually any purpose. The loans typically come with a fixed interest rate and involve making fixed payments over a set term, typically one to five years. Unlike home equity loans, HELOCs, and cash-out refinances, these loans are typically unsecured, meaning you don’t use your home or any other asset as collateral for the loan. Personal loans usually come with higher interest rates than loans that are secured by collateral.

Pros of Cash-Out Refinancing

•  A lower mortgage interest rate With a cash-out refinance, you might be able to swap out a higher original interest rate for a lower one.

•  Lower borrowing costs A cash-out refinance can be less expensive than other types of financing, such as personal loans or credit cards.

•  May build credit If you use a cash-out refinance to pay off high-interest credit card debt, it could reduce your credit utilization (how much of your available credit you are using), a significant factor in your credit score.

•  Potential tax deduction If you use the funds for qualified home improvements, you may be able to deduct the interest on the loan when you file your taxes.

Cons of Cash-Out Refinancing

•  Higher cost than a standard refinance Because a cash-out refinance leads to less equity in your home (which poses added risk to a lender), the interest rate, fees, and closing costs are often higher than they are with a regular refinance.

•  Mortgage insurance If you take out more than 80% of your home’s equity, you will likely need to purchase private mortgage insurance (PMI).

•  Longer debt repayment If you use a cash-out refinance to pay off high-interest debts, you may end up paying off those debts for a longer period of time, potentially decades. While this can lower your monthly payment, it can mean paying more in total interest than you would have originally.

•  Foreclosure risk If you borrow more than you can afford to pay back with a cash-out refinance, you risk losing your home to foreclosure.

Is a Cash-Out Refi Right for You?

If you need access to a lump sum of cash to make home improvements or for another expense, and have been thinking about refinancing your mortgage, a cash-out refinance might be a smart move. Due to the collateral involved in a cash-out refinance (your home), rates can be lower than other types of financing. And, unlike a home equity loan or HELOC, you’ll have one, rather than two payments to make.

Just keep in mind that, as with any type of refinance, a cash-out refi means getting a new loan with different rates and terms than your current mortgage, as well as a new payment schedule.

Turn your home equity into cash with a cash-out refi. Pay down high-interest debt, or increase your home’s value with a remodel. Get your rate in a matter of minutes, without affecting your credit score.*

Our Mortgage Loan Officers are ready to guide you through the cash-out refinance process step by step.

FAQ

Are there limitations on what the cash in a cash-out refinance can be used for?

No, you can use the cash from a cash-out refinance for anything you like. Ideally, you’ll want to use it for a project that will ultimately improve your financial situation, such as improvements to your home.

How much can you cash out with a cash-out refinance?

Often lenders will allow you to borrow up to 80% of your home’s value, including both the existing loan balance and the amount you want to take out in the form of cash. However, exactly how much you can cash out will depend on your income and credit history. Also, you typically need to be able to maintain at least 20% percent equity in your home after the cash-out refinance.

Does a borrower’s credit score affect how much they can cash out?

Yes. Lenders will typically look at your credit score, as well as other factors, to determine how large a loan they will offer you for cash-out refinance, and at what interest rate. Generally, you need a minimum score of 620 for a cash-out refinance.

Does a cash-out refi hurt your credit?

A cash-out refinance can affect your credit score in several ways, though most of them are minor.

For one, applying for the loan will trigger a hard pull, which can result in a slight, temporary, drop in your credit score. Replacing your old mortgage with a new mortgage will also lower the average age of your credit accounts, which could potentially have a small, negative impact on your score.

However, if you use a cash-out refinance to pay off debt, you might see a boost to your credit score if your credit utilization ratio drops. Credit utilization, or how much you’re borrowing compared to what’s available to you, is a critical factor in your score.

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While it’s unlikely that Social Security will ever run out completely, current predictions are that benefits could be reduced by as much as 20% by 2034 — unless Congress intervenes.

Why is that?

Imagine the Social Security system as a bucket of water. Current workers pay Social Security tax that’s added to the bucket, while retired workers withdraw their benefits from the resources in the bucket.

Throughout Social Security’s almost 90-year history, there was always a surplus of funds. More people were paying into the system than were withdrawing from it.

Over time, for various reasons — including a smaller pool of younger workers and a longer-living pool of retirees — those excess resources have been slowly depleted. Given the demands on the system, it’s unclear how to keep Social Security functioning unless benefit payouts are cut, or the government takes some kind of action.

How Social Security Works

The American Association for Retired Persons (AARP) describes Social Security as a “pay-as-you-go” system, meaning that the contributions made by workers now (through the Social Security payroll tax) are actually used to pay the benefits of today’s retirees. Currently some 180 million workers pay into the system, which provides Social Security and Disability benefits for 66 million people.

When today’s workers retire, the idea is that they will receive benefits based on what the next generation contributes. Any money that’s left over goes into one of two Social Security trust funds.

According to the Social Security Trustees report published in March 2023, total costs of the OASI and DI Trust Funds (Old Age and Survivors Insurance, and Disability Insurance) the system began to outstrip total income in 2021, and the reserves of the OASI and DI Trust Funds declined by $22 billion in 2022 to $2.83 trillion.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

Understanding Social Security Tax

The amount each individual worker contributes to Social Security depends on their income. Employees who work for a traditional employer split the Social Security tax payment with their employer at 6.2% each up to $162,200 in annual salary, and self-employed workers are responsible for the entire 12.4%.

As employees contribute to the tax, they earn Social Security “credits” — with a max of four per year.

Those employees become eligible for benefits when they reach 40 credits, which equals roughly 10 working years, or they reach full retirement age. For Americans born in 1960 or later, that’s 67 years old.

At What Age Are You Eligible for Social Security?

Getting the most out of Social Security benefits becomes a numbers game as workers get close to retirement age, because workers are technically eligible at age 62. But for each month previous to full retirement age that someone starts drawing benefits, they’re reduced by one-half of one percent.

According to the SSA, that means if a worker’s full retirement age is 66 and 8 months and they start drawing Social Security at age 62, they’ll only get around 71.7% of their full benefit.

The benefits stop increasing at age 70, and the AARP reports that workers who are able to wait that long get the most return — full benefit plus delayed retirement credits — but individual decisions should be made on a number of factors, including employment outlook and health.

Recommended: When Can I Retire?

Social Security Trust Funds

After all the contributions have been paid in and benefits paid out, any remaining funds are divided up between two trust funds, divided up between the Old-Age and Survivors Insurance (OASI) Trust Fund and the Disability Insurance (DI) Trust Fund, where they earn interest in government-guaranteed Treasury bonds.

The larger of the two funds, the OASI, pays benefits to retired workers, their surviving spouses and eligible children, and covers administrative and other expenses. It’s the largest fund that takes care of retirees who don’t face special circumstances, and deposits are made daily. It’s been around since 1940.

The smaller DI Trust Fund handles monthly benefit payments to disabled workers and their spouses and children until they’re eligible for full benefits through the OASI.

Even though both funds are a part of the overall federal budget, they’re handled separately and the SSA isn’t allowed to pay out more than what’s in the trust fund.

Recommended: Top 5 Social Security Myths

Risk of Social Security Running Out

Media headlines in recent years have highlighted concerns over a potential Social Security funding shortfall. But it’s important to separate fact from fiction when understanding how Social Security works.

Myth 1: There won’t be any money to pay benefits

As mentioned, the odds of Social Security running out of money completely are low. Remember, Social Security is pay as you go with today’s workers paying in funds that are used to provide retirement benefits for today’s retirees.

When you retire, your benefits would be paid by those still working. So unless the system itself is abolished, Social Security benefits would continue to exist and be funded by workers.

Reality: Social Security surplus funds may be exhausted

While workers pay into Social Security, the program also has a surplus of trust funds that it can use to pay benefits, as described earlier. The program has begun using those funds to pay some benefits as of 2021, with payroll taxes continuing to pay the majority of benefits to retirees.

While Social Security itself is unlikely to end, the trust funds may eventually be spent down to $0, which presents the possibility of a reduction in future benefits.

Myth 2: People who aren’t eligible for Social Security can receive it

Another concern about the possibility of Social Security running out stems from the mistaken belief that undocumented individuals can illegally claim Social Security benefits.

The idea is that some people might unfairly claim benefits they’re not entitled to, putting a burden on the system and reducing benefits for eligible workers.

Reality: Documentation is required to obtain benefits

A Social Security number or Individual Taxpayer Identification Number is required for the Social Security Administration to create a benefits record for a citizen or non-citizen who’s authorized to work in the U.S. Someone who has either could legally obtain benefits through Social Security since they’ve technically paid into the system.

Myth 3: The current system can’t support an aging population

As life expectancies increase and the birth rate declines, it’s natural to assume that living longer may affect Social Security’s ability to continue paying out benefits. Someone who’s 25 now, for example, may be wondering what year will Social Security run out and how will it time up with my retirement?

Reality: Social Security can adapt

While there’s little the government can do to change the demographic makeup of the population, lawmakers can be proactive in proposing changes to Social Security. That includes measures that can help to preserve benefits for as many workers as possible while minimizing the odds of running out of funding.

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Problems With Social Security

Because benefit payouts are tied to the SSA’s reserve balance, it begs a question for many working Americans — what happens when that balance hits zero? The SSA itself acknowledges that benefits will likely only be available in full until 2035. That’s just 11 years away.

Reasons for the depletion of fund reserves are attributed to a number of challenges, including a rise in program costs. Cost-of-living adjustments, or COLA, have been steadily increasing. Life expectancy for Americans has grown longer, while the number of workers hasn’t kept pace with the number of retirees.

How to Avoid Social Security Running Out

Lawmakers, financial experts, and retirement advocates are starting to float ideas for how to save the program. To date, the two ideas that have been floated include raising the Social Security tax or reducing the benefit — two options that are likely to be unpopular with both workers and retirees.

There are many details on how to implement those two ideas. Some business publications say that the deficit could be eliminated with a combination of both that aggregate to 2.84% of payroll — that equals less than 3 cents for each dollar earned, and it would be split by workers and employers.

Another proposed fix, called the Social Security 2100 Act, would make a number of changes to the current system, such as changing the formula for COLA to use a Consumer Price Index for the Elderly (versus its current price index for wage earners).

It would also involve setting the new minimum benefit at 25% above the poverty line. Advocates say the result would be like getting a 2% raise of the average benefit.

History of Early Social Security

The need to secure a financial future for ourselves and our loved ones isn’t new — or uniquely American. Across the pond, the English passed a series of “Poor Laws” around 1600 intended to ensure that the state provided for the welfare of its poorest citizens.

Americans were quick to embrace the idea that the country should take care of its people, but at first it wasn’t society at large. In 1862, for example, a post Civil War-era program offered pensions to disabled Civil War soldiers, and widows and children of the deceased.

Around the late 1800s, some private companies were starting to offer pension plans too. The first company to offer a real pension plan was the Alfred Dolge Company, which made pianos and organs. They took 1% of an employee’s salary and put it into a pension plan, and then added 6% interest per year.

In 1935, President Franklin D. Roosevelt signed into law the Social Security Act. The government then started collecting Social Security taxes two years later. Then on January 31, 1940, the first monthly retirement check of $22.54 was issued to Ida May Fuller in Ludlow, Vermont.

This Isn’t the First Social Security Shortfall

The retirement en masse of America’s Baby Boomers and parallel decline in birth rate is taking the blame for Social Security’s current problems. But this isn’t the first time the fund has been in trouble.

When the program first began phasing in, for example, workers were contributing but no one was retiring yet, so the fund grew a nice little surplus. Congress, seeing those nice big numbers, were generous with increasing benefits every time they had the chance.

When the 1970s rolled around, however, and those workers reached retirement age, that upward momentum came to a screeching halt. On top of that, a flaw in the program’s COLA formula caused benefits to double-index, or increase at twice the rate of inflation rather than matching it.

It became such a mess that task forces were created, the error got its own name “The Notch Issue,” and instead of making changes to Social Security during even years, because increases and expansions were good for election campaigns, Congress made changes on odd-numbered years.

Social Security Amendments of 1983

Amendments in 1983 addressed the financing problems to the Social Security system. These changes were the last major ones to the program and were based on recommendations from a commission chaired by Alan Greenspan.

The Greenspan Commission adjusted benefits and taxes. The resulting reforms have generated surpluses and the buildup of a trust fund. However, many experts project that the retirement of the baby boomers, along with other demographic factors, will exhaust the trust.

What Can I Do About Social Security?

The SSA allows contributors to keep track of their Social Security accounts online, work with retirement and benefits estimation tools, and even apply for retirement benefits online.

Perhaps the two most important tools in the journey toward retirement are education and planning — knowing where you are, where you want to be, and what you need. Understanding the ins and outs of the ideal retirement age, whether that’s through Social Security or private retirement savings plans, and how to avoid penalties can help form a solid plan.

Aside from government benefits, one of the easiest steps for traditionally employed workers is to take full advantage of their employer’s 401(k) matching plans. These are programs in which the employer can match what you contribute to the 401(k).

If your employer doesn’t offer a 401(k) or matching plan, consider setting up an IRA or Roth IRA. Regular IRAs are tax-deductible like 401(k)s, meaning you’re not taxed until your withdrawal in retirement. Meanwhile, contributions to Roth IRAs are not tax-deductible, but you can withdraw money tax-free in retirement.

The Takeaway

Without fixes, the cash reserves of the SSA will become depleted and workers who reach full retirement age after 2034 will likely receive a reduced benefit amount.

It can be a scary proposition for some, but knowing that the deadline is approaching is a huge advantage in that members of the workforce who have time to take measures to counter the expected shortfall by saving more and adjusting their financial plans.

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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