Cash-Out Refinance: A Homeowner’s Guide to How it Works
What You Should Know
- A cash-out refinance lets you borrow money using your home equity.
- You can withdraw the difference between the new and old mortgage.
- This cash can be used for any purpose, such as renovations and debt consolidation.
- Most lenders allow a max LTV of 80%. Some lenders allow up to 90% or 100%.
Cash Out Refinancing Rates
What Is A Cash-Out Refinance?
A cash-out refinance allows you to borrow against your home equity at a low interest rate. It works by borrowing a loan amount larger than your existing outstanding balance. The cash you receive is the difference between your new and existing mortgage. These funds can be used for any purpose, such as debt consolidation, remodeling, and home renovations.
However, money from a cash-out refinance isn't free money. You will eventually need to pay the borrowed money back, which is done with your regular mortgage payments. That's why funds from a cash-out refinance are generally used for purposes that have a lasting benefit, such as saving you interest or increasing your home value.
Additionally, since you are replacing your existing mortgage with a new mortgage, you'll be able to change the terms of your mortgage when refinancing. In addition to receiving cash, a cash-out refinance allows you to;
- Change your monthly mortgage payments .
- Refinance to a shorter term to save on interest.
- Refinance to a longer term to reduce your monthly payments.
- Negotiate your mortgage interest rate.
Cash-out refinancing can be a powerful tool to access leverage, but it is also important to understand the downsides associated with it. When you leverage using your home equity, you may put yourself at risk of foreclosure. Your monthly mortgage payments may also increase as well as the term of your home loan. Make sure to estimate your new mortgage before proceeding with the cash-out refinance.
| FHA | VA | USDA | |
|---|---|---|---|
| Cash Out Ability | Yes | Yes | No |
| Maximum LTV | 80% | 100% | N/A |
| Maximum Loan Amount | Yes | No | No |
| Maximum Income | No | No | Yes |
- 80% LTV with conventional cashout
- 80% LTV with FHA cashout
- 100% LTV with VA cashout
How Does a Cash Out Refinance Work?
A cash-out refinance turns your home equity into cash without selling your home. This is done by borrowing a larger mortgage loan than you currently owe. The amount that you can borrow with a cash-out refinance depends on how much equity you own. When you make mortgage payments, a portion goes towards your principal, while the other is the mortgage interest cost .
Your principal payments turn into home equity that you own. Generally, you can borrow up to 80% of your home's value. This means that cash-out refinancing won't be an option until you own at least 20% equity in your home. It also means that a cash-out refinance will always increase your mortgage balance and decrease your home equity.
Since you are paying off your existing mortgage with a new mortgage loan, you will end up with only one larger mortgage. A cash-out refinance is not a second mortgage in addition to your existing mortgage. Since it is a new mortgage, you will have to pay closing costs for a cash-out refinance. Refinancing closing costs can add up from 3% to 5% of the new loan amount. This can include the cost of mortgage origination fees and home appraisal fees.
It can take a few days after closing to receive your cash-out, usually in the form of a check. You can deposit the check into your bank account and use the money without limitations.
Cash-out refinances have a three-day right of rescission period. During these three days, borrowers can choose to cancel the cash-out refinance. Once that period has passed, you will receive the check from the cash-out refinance.
You can waive your right of rescission to receive cash-out refinance money faster under certain circumstances. To waive your right of rescission, you must provide a written statement detailing your financial emergency and how it requires you to receive the money before the end of the required waiting period.
| Important Formulas | ||
|---|---|---|
| Home Equity = Home Value - Mortgage Balance | ||
| Cash-Out Amount = New Mortgage Amount - Old Mortgage Balance |
How Much Can I Borrow in a Cash-Out Refinance?
The amount of money you can get from a cash-out refinance depends on your home value, existing mortgage debt, and the maximum loan-to-value (LTV) ratio allowed by your cash-out refinance lender. Home equity is the difference between your home’s appraised value and your existing mortgage balance. With a higher mortgage debt, you’ll have less home equity. As a result, you won’t be able to borrow as much as someone with more home equity.
Home equity is calculated as loan to value (LTV). This is the ratio of your mortgage balance to your home’s value. For example, a $100,000 home with a $60,000 mortgage would have an LTV of 60%. Most of your lender's attention will be on your LTV ratio. Most cash-out refinance lenders allow for a maximum LTV ratio of 80%. This means you won't be able to cash out at least 20% of your home's value. You can use a cash-out refinance calculator to determine how much cash you can borrow.
The maximum amount you can borrow can also be limited based on your loan type. For example, FHA cash-out refinancing has a maximum loan limit based on your county's FHA loan limit. In most areas, the 2023 FHA loan limit is $472,030. However, the FHA limit can increase to $1,089,300 in some high-cost areas. You won't be able to get an FHA cash-out refinance for more than this amount.
Additionally, some jumbo loan lenders might also have restrictions on jumbo loan cash-out refinances. For instance, they might require a piggy-back loan of 75/10/15.
Yes, you can borrow more money from a cash-out refinance above an 80% LTV with a VA loan. VA loans allow you to cash out refinance up to 100% of your home's value. FHA loans no longer enable you to exceed an 80% LTV for cash-out refinances. Some lenders may offer conventional cash-out refinances for up to 90% LTV. However, you will need to pay for private mortgage insurance (PMI) if your cash-out refinance causes your mortgage to end with an LTV of 80% or more.
Cash Out Refinance Example
To see an example of how a cash-out refinance works, let's assume the following information:
- Your home value is $350,000.
- Your current mortgage balance is $250,000.
- Your lender enables you to borrow up to an LTV ratio of 80%.
So, how much cash can you get from a cash-out refinance?
First, you will need to calculate your maximum borrowing amount. Your lender has a max LTV ratio of 80%. The LTV ratio is based on the loan amount compared to the value of your home. 80% of your home's value is $280,000. You can get a mortgage for up to $280,000 based on your home value of $350,000.
Second, you will decide how much more you want to borrow over your current mortgage amount of $250,000. If you borrow the maximum amount of $280,000 and use it to pay off your existing mortgage, you are left over with $30,000. This $30,000 is the amount in cash that you can withdraw. Otherwise, you can simplify the process by using a cash-out refinance calculator.
To cash out refinance for up to 100% of your home value, you will need to refinance with a VA loan. A VA cash-out refinance has a max LTV ratio of 100%, depending on your lender. However, you will need to meet the requirements of a VA loan. This includes being a qualified veteran or service member.
Cash-Out Refinance Requirements
Having enough home equity doesn't mean you are automatically approved for a cash-out refinance. You will still need to meet lender requirements. These are typically the same as a regular refinance and include the following:
- Credit Score: The minimum credit score for a conventional cash-out refinance is 620. For an FHA cash-out refinance and VA cash-out refinance, some lenders may allow a minimum credit score of as low as 580.
- Debt-to-Income (DTI) Ratio: A maximum DTI ratio of 43% is allowed by lenders. However, some lenders can go up to 50%. The DTI calculation will include your new mortgage loan amount.
- Home Appraisal: An appraisal is required to determine the value of your property.
- Financials: Employment, credit records, assets, bank statements, and income tax returns will be required for the refinance process.
- LTV Ratio: The maximum loan-to-value (LTV) ratio for a conventional cash-out refinance is 80%. In other words, you will need to have at least 20% equity to qualify for a cash-out refinance. VA cash-out refinancing may allow for a higher LTV ratio.
Advantages and Disadvantages of a Cash-Out Refinance
| Advantages | Disadvantages |
|---|---|
|
|
Advantages
- Lower Mortgage Rate: Most people refinance when the current mortgage rate is lower. This can save you money through lower monthly payments and less interest paid in total. For example, a 1.75% decrease in your interest rate could change your monthly payment from $3,000 to $2,625. This 12.5% difference assumes a $400,000 home with a 30-year fixed rate at 4.00% vs. 2.25%. Use our refinance calculator to determine your total savings from refinancing.
- Consolidating Debt: If you have other forms of debt, such as credit cards or student loans with very high interest rates, then a cash-out refinance at a lower rate can help you save on interest payments in the long run.
- Credit Score: You can improve your credit score if you pay off your credit cards and other debt with the funds you get from the cash-out refinance. This is because it will lower your credit utilization ratio.
- Tax Deductions: You can deduct interest costs if the refinance increases your home’s value through renovations or safety standards. This can include adding a swimming pool, adding a fence to the boundary, roof repair, temperature control systems, and security systems.
Disadvantages
- Collateral: If you frequently miss mortgage payments, your lender can foreclose your home by claiming the collateral. Therefore, knowing the risks of using a cash-out refinance is essential.
- Refinance Fees: To obtain a cash-out refinance, you must pay refinancing fees ranging from 3% to 5% of the new loan amount.
- Mortgage Insurance: You must get private mortgage insurance (PMI) if you borrow more than an 80% loan-to-value (LTV) ratio. This protects the lender if you default on your repayments and has fees ranging from 0.4% - 2.25% of the loan amount.
- New Loan Terms: If rates have risen since your original mortgage, it might mean refinancing into a higher mortgage rate. Additionally, if you reset your loan term to 30 years, you will need to make mortgage payments for the next 30 years.
Types of Cash-Out Refinances
Cash-out refinance has been increasingly popular among US borrowers in the past years. Low interest rates allowed many borrowers to take an opportunity to refinance their mortgages at better rates and receive some cash for it. As the rates start to climb again, it is important to understand what cash-out refinancing options are available and what may work best.
Total Home Equity Cash Out Per Year
In Billions, Inflation Adjusted to 2021
Source: Freddie Mac
FHA Cash-Out Refinance
An FHA cash-out refinance is when you replace your current mortgage with a new FHA loan. You don't need an existing FHA loan to get an FHA cash-out refinance. The benefit of a cash-out refinance to an FHA loan is that they have lower minimum credit score requirements and may have lower interest rates.
There are two maximum lending constraints with an FHA cash out refinance. Initially, you will only be able to borrow up to an 80% LTV with an FHA cash-out refinance. FHA loans also have a maximum regional loan limit. While this varies by county and the number of units, the 2023 baseline is $472,030. Aside from the two constraints, an FHA cash-out refinance has additional requirements compared to a conventional refinance. This includes:
- You must have lived in the home being refinanced for at least 12 months as your primary residence.
- Your mortgage payments for the past 12 months must have been paid on time.
For example, you cannot get an FHA cash-out refinance for a vacation home, second home, or rental property, while a conventional cash-out refi allows you to do so. Since you are getting an FHA loan, you will also need to pay FHA mortgage insurance premiums (MIP) regardless of your LTV ratio. This includes both an upfront fee and an annual fee. With a conventional cash-out, you can avoid paying for mortgage insurance by keeping your LTV under 80%.
VA Cash-Out Refinance
A VA cash-out refinance loan, also called a Type 2 cash-out refinance, allows eligible borrowers to refinance to a max LTV of 100%. This means you can cash out up to 100% of your home equity. You don't need an existing VA loan to get a VA cash-out refinance, either. However, since you are getting a new VA loan, you will need to be eligible by being a veteran or service member. The max LTV limit for a VA cash-out refinance in Texas is also limited to 80%.
Like an FHA cash-out refinance, you cannot cash-out refinance a vacation home or second home with a VA loan. Instead, VA cash-out refinancing can only be done for owner-occupied dwellings. There is no maximum loan amount for a VA cash-out besides the maximum LTV limit of 100%. For example, if your home value is $800,000, you may qualify for a VA cash-out refinance of up to $800,000 before closing costs.
You will still need to pay the VA funding fee for a VA cash-out refinance. The VA funding fee for a first-time VA cash-out refinance is 2.3% of the loan amount, and subsequent cash-outs have a VA funding fee of 3.6%. This makes it equivalent to a VA funding fee for a VA loan with a down payment of less than 5%.
USDA Cash-Out Refinance
You cannot cash out refinance a USDA loan. However, you can get a USDA construction loan to build or repair a home. To finance your home repairs, you may borrow up to 100% of your home's appraised value. This construction loan can finance the whole construction project or partially contribute to the project.
For example, a USDA construction loan can be used to buy concrete for the foundation. A borrower could estimate the amount of concrete needed for their project and request a loan for that amount. The use of the funds is limited to construction and repairs only. This makes it a much more limited option compared to a cash-out refinance.
Cash-Out Refinance Closing Process
A regular "rate and term" refinance will generally take around 30 to 45 days, while a cash-out refinance can take between 45 to 60 days. The cash-out refinance process is longer and may involve more paperwork than a traditional home refinance.
Your income and employment will need to be verified. You might be required to provide pay stubs and W-2 forms. It's a good idea to compare mortgage lenders for the best rates, as you aren't required to get a cash-out refinance with your current lender. Refinancing with the same lender can simplify and shorten the closing process.
For closing, you will need to bring your ID, proof of homeowners insurance coverage, such as a homeowners insurance binder, and payment for the closing costs. You can pay the cash-out refinance closing costs at closing, or you can have it included in your mortgage loan balance. Rolling the closing costs into your loan balance is similar to a no-closing-cost mortgage, as it allows you to avoid paying them upfront.
Taxes on Cash Out Refinances
The cash you receive from a cash-out refinance is not considered income. Instead, the cash amount is viewed as a loan. This means you do not pay taxes on cash from a cash-out refinance. You can use the money received from a cash-out refinance for anything, such as paying off debt or a vacation.
In some cases, you may even deduct the interest when filing your taxes if you use the cash-out refinance for home improvements, such as fixing your roof or adding an addition to your home. To qualify for the mortgage interest deduction, the cash from a cash-out refinance would need to be used for improvements that increase your home's value.
Using your cash-out refinance money for other purposes - such as debt consolidation or a vacation - won't allow you to deduct the new mortgage interest. Instead, you will only be able to deduct interest from your original mortgage balance.
For example, let's say that your original mortgage is $200,000. You want to borrow an extra $100,000 to replace your roofing, build a new bedroom, and remodel your kitchen. With a cash-out refinance of $300,000, the entire interest cost is eligible for the mortgage interest deduction. If you borrow $100,000 to consolidate debt and for other spending, then only the interest on the original mortgage balance of $200,000 is eligible for the interest deduction.
Cash-Out Refinancing Alternatives
Home Equity Line of Credit (HELOC)
If you have had a mortgage for a couple of years, you have probably increased your equity or ownership stake in the home. A home equity line of credit (HELOC) lets you borrow funds against the equity that you own in the home, using the home as collateral. It works like a credit card where funds can be borrowed and repaid, providing flexibility to the borrower. To calculate your monthly expenditure with a HELOC, use our HELOC payments calculator.
Home Equity Loan
In this type of loan, you can borrow a lump-sum amount depending on how much equity you own in the home. It is similar to a HELOC, as home equity determines how much you can borrow, and the house is the collateral. However, in a home equity loan, you receive a lump-sum amount rather than a revolving credit. If you are unsure which type of home equity loan is best, you can review our article comparing HELOCs vs. Home Equity Loans.
Personal Loan
You can borrow funds without putting up your home as collateral by taking a personal loan. The interest rate charged for a personal loan is higher than a HELOC or home equity loan, as the lender has a higher risk due to the lack of collateral.
Reverse Mortgage
A reverse mortgage allows senior homeowners to borrow money using their home equity without needing to make any further mortgage payments. The lender can pay you through installments to set up a steady cash stream, or you can receive a lump sum.
Instead of making mortgage payments, the interest accumulates and is taken out of your home equity. This type of loan is used by senior citizens who use their equity in the home to receive monthly payments from lenders, creating another source of income during retirement.