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Cash-Out Refi 101: How Cash-Out Refinancing Works

By Jody McMaster · November 03, 2022 · 5 minute read

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Cash-Out Refi 101: How Cash-Out Refinancing Works

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.

It’s a good idea, though, to size up current mortgage rates, closing costs, and alternatives.

What Is a Cash-Out Refinance?

A cash-out refinance is one way for homeowners to access a lump sum of cash.

Borrowers with sufficient home equity take out a new mortgage for a larger amount than the existing mortgage and receive the difference in cash.

How Does a Cash-Out Refinance Work?

If you apply for a refinance with cash out, you’re asking for a new mortgage that will pay off your current mortgage and give you a lump sum — but it typically will not be based on 100% of your home’s value.

For most conventional mortgages and for FHA loans, your cash-out refinance loan amount cannot exceed 80% of your home’s value. So to cash out, you must have more than 20% home equity.

Put another way, most lenders require a loan-to-value ratio of no more than 80%.

The new loan’s interest rate, term, and monthly payment may all be different.

Example of Cash-Out Refinancing

Let’s say your home is worth $360,000, and you owe $260,000 on your mortgage (and you do not have a second mortgage).

You have $100,000 in equity, but that doesn’t mean you’ll get a $100,000 check at closing.

Most lenders will calculate 80% of the home’s value — $288,000 in this case, the maximum LTV. A new loan of $288,000 will pay off your existing mortgage balance and provide $28,000 in cash, minus prepaids and closing costs.

Closing costs may be 2% to 5% of the new total loan amount. A “no closing cost refinance” does exist, but a borrower either adds the closing costs to the principal or exchanges them for an increased interest rate.

Common Uses of Cash-Out Refinancing

You can use the cash for any purpose, although putting it toward long-term needs makes the most sense.

Uses may include:

•   Home renovations that add value, like remodeling a kitchen

•   Buying a vacation home

•   Purchasing a multifamily property

•   Paying off credit card debt

•   Funding private or public college

•   Adding an accessory dwelling unit (ADU)

Qualifying for a Cash-Out Refinance

Lenders consider a number of factors besides equity in the home. Here are some.

Credit score: A good or great credit score could help borrowers secure a more competitive interest rate on their cash-out refi. In the typical credit rating scale of 300 to 850, a good FICO® credit score falls in the range of 670 to 739.

DTI ratio: Lenders will look at your debt-to-income ratio — monthly debts compared with gross monthly income — to gauge whether you can take on additional debt. A cash-out refinance usually requires a DTI of 45% or under.

Steady income and employment.

Appraisal value: Lenders require a home appraisal for a cash-out refinance.

When you closed: You’ll usually need to wait at least six months after you closed on your property before you can apply for a cash-out refinance of a conventional mortgage or VA loan.

Tax Considerations

A cash-out refinance may be eligible for the mortgage interest deduction if the money is used to make capital improvements to your home (not just make repairs).

Discount points, or mortgage points, are deductible when the cost is spread over the life of the loan.

And the cash from your refinance is not treated as reportable income.

Cash-Out Refi vs Home Equity Loan or HELOC

If a lower interest rate is your goal but you are unable to get one, there are options to acquire cash that may be worth considering. Here are three.

Home Equity Line of Credit

A home equity line of credit (HELOC) is a revolving line of credit that uses the borrower’s house as collateral.

Most HELOCs have a 10-year draw period, when you can draw money, pay it back, and take out some more, up to your approved credit line. Payments are typically interest only on the amount borrowed. After the draw period ends, the credit line closes and payments with principal and interest begin.

HELOCs typically have variable rates.

Home Equity Loan

Unlike a HELOC, a home equity loan is a lump-sum loan that is repaid in fixed payments.

Home equity loans often have a fixed interest rate and are typically chosen when borrowers know how much cash they will need.

A home equity loan also uses the borrower’s house as collateral. Both the loan and a HELOC typically allow you to borrow up to 85% of your home equity.

Personal Loan

Personal loans are typically unsecured, which means they do not require assets (like your home) as collateral. Personal loans usually come with higher interest rates than loans that are secured by collateral.

Benefits of Cash-Out Refinancing

That wad of cash: The biggest advantage of a cash-out refinance is that you get the money you need by tapping your equity.

Potentially lower rate: Borrowers with a strong credit history may be able to refinance to a lower interest rate than a home equity loan or personal loan.

Possibly improved credit score: Using the money to pay off high-interest credit card debt could reduce your credit utilization — as long as you no longer use those cards.

Disadvantages of Cash-Out Refinancing

Reduction in equity: Increasing the lien on your home reduces the amount of available equity, which can be further reduced by downward market fluctuations. Equity is an asset that can build generational wealth.

Risk of foreclosure: Using your home as collateral is a risk. If for some reason you can’t make the mortgage payments, the bank could foreclose on the home.

Closing costs: Borrowers usually have to pay closing costs.

Mortgage insurance: Private mortgage insurance will be charged on loans that exceed 80% of the home’s value.

Is a Cash-Out Refi Right for You?

If you’re sitting on a heap of home equity and need a chunk of money, a cash-out refinance might be tempting. Consider the rates and the amount of time it would take to pay back the additional funds, calculate the closing costs, and weigh the options.

SoFi offers personal loans of up to $100,000 and a HELOC for 95%, or $500,000, of your home equity.

If a cash-out refinance seems right, SoFi offers that, too.

FAQ

Are there limitations on what the cash can be used for?

No, but remember that a cash-out refinance means removing equity and using your home as collateral. So some uses are wiser than others.

How much can you cash out?

For most mortgages, the cash-out refinance loan amount cannot exceed 80% of the home’s appraised value. VA loans are an exception: A borrower may get a cash-out refi for 100% of the home’s value, though many lenders cap LTV at 90%.

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

A credit score influences loan approval and the rate offered more than anything. Many lenders look for a credit score of at least 620, but some accept lower scores.

Does a cash-out refi hurt your credit?

A bigger loan balance could increase a borrower’s credit utilization ratio, but refinancing should have little, if any, lasting impact on most people’s credit scores.


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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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