What we'll cover
Requirements for a cash-out refinance loan
How to calculate your loan-to-value ratio
Pros and cons of a cash-out refinance loan
If you’re exploring a mortgage refinance to take advantage of lower rates or to free up funds, a cash-out refinance may be an option worth considering.
A cash-out refinance is a way to borrow money against your home equity by taking out a new mortgage loan. It returns some of your equity to you in the form of cash to handle home repairs or renovations, consolidate debt or fund another financial goal.
Keep in mind that taking out a cash-out refinance loan assumes you:
Have sufficient equity to borrow against
Meet the qualification requirements set by your lender
Have the cash to cover closing costs
Have the means to repay the new mortgage loan
If you're confident on all these fronts, here's a closer look at how cash-out refinancing works.
What is a cash-out refinance loan?
Ordinarily, refinancing a mortgage means getting a new home loan to replace your existing one. This new loan can have a shorter or longer repayment term and a different interest rate than your previous loan.
Cash-out refinancing works differently. With this type of loan, you get a brand-new loan to replace your old one and you withdraw part of your home equity at closing. This home equity is paid out to you as cash in a lump sum. You can then use the money as you see fit.
It’s different from a home equity line of credit (HELOC) or a home equity loan. With a HELOC, you still borrow against your home equity, but instead of a lump sum, you have access to a line of credit you can draw against as needed. A home equity loan offers lump-sum funding, but it’s the equivalent of a second mortgage on your home.
How a cash-out refinance loan works
Cash-out refinancing doesn’t mean you can withdraw all of your home equity. Instead, lenders limit you to withdrawing a set percentage of equity in cash.
Lenders typically cap the percentage at 80% of your total loan-to-value (LTV) ratio. The LTV ratio is typically less strict with government-backed home loans, such as USDA or FHA loans. Do a little math to determine how much equity you have available and how much you can borrow against.
For example, say the original value of your home was $300,000. You currently owe $200,000 toward the remaining balance. That puts your LTV ratio at 67%. Assuming your chosen lender limits you to an 80% LTV for a cash-out refinance, you can pull $40,000 out of your home.
It's also worth mentioning that you must meet the other requirements set by your mortgage lender to qualify for cash-out refinancing. Aside from checking your LTV ratio, your lender could also consider your credit score, income and debt-to-income ratio (DTI) when deciding whether to approve you for a cash-out refinance.
Advantages of a cash-out refinance
With a cash-out refinance, your new mortgage might have a lower interest rate than your original mortgage. That scenario can become a reality if interest rates have dropped since you purchased your home. Other perks may include:
Having money in hand: Cash-out refinancing can put money in your hands when you need it. If you have high-interest credit card debt, using a cash-out refi for debt consolidation may make sense if you're able to get a lower interest rate on the loan.
Meeting other financial needs: You could also use a cash-out refinance loan to meet other financial needs, such as covering medical expenses in a financial emergency, paying for a wedding or footing the bill for college expenses so your child can avoid student loans.
Tax breaks: Cash-out refinance loans can yield tax breaks for some homeowners. If you're using a refinance loan to get cash for home improvements or renovations, the interest on the loan could be tax-deductible.
Cash-out refinance drawbacks
Before deciding if cash-out refinancing could make sense, consider these potential downsides:
Collateral: Your home serves as the collateral for the loan. If you cannot make your monthly payment and end up defaulting, your mortgage lender could initiate a foreclosure proceeding against you. That means losing the home and severely damaging your credit score.
Closing costs: Cash-out refinancing isn't free, and the closing costs can easily add up. Costs can also increase if your new loan has a higher interest rate. A higher rate means more interest paid total over the life of the loan.
New debt: Cash-out refinancing creates new debt because you're increasing the amount you must repay to your mortgage lender.
Compare cash-out refinance rates
It's important to consider your new monthly payment after cash-out refinancing. You can run the numbers through our refinance calculator or talk to a mortgage lender about what your new payment may add up to.
Remember to shop around and carefully compare rates from at least a few mortgage lenders before you sign the dotted line — that way, you can feel confident you’re getting the best rate possible.
