Cash-Out Refinance: What It Is And How It Works

We all have debts and expenses that we’d take care of if we had an extra $20,000 laying around. Unfortunately, it can be hard to save that kind of money on top of paying for basic living costs.

But there’s good news. A mortgage refinance, specifically a cash-out refinance, allows homeowners to free up the valuable equity they’ve built in their homes. This money can be used on everything from home renovations to paying off other loans or even financing a vacation.

Here’s what you should know about cash-out refinances and why it might be a good option for you.

A cash-out refinance is a type of refinance that allows homeowners to borrow money against the equity they have built up in their homes. With a cash-out refinance, the homeowner takes out a new mortgage that is larger than their current mortgage balance. The existing first mortgage is paid off and the difference between the two loans is paid out in cash to the homeowner.

You can refinance and withdraw some of your equity, usually up to 80%, as cash that you can spend. So, if you had $60,000 worth of equity, you might be able to withdraw around $48,000 to use for renovations, paying off other loans, etc.

When you do a cash-out refinance, you essentially get a new loan, borrow more than you owe on the existing mortgage and take the difference in cash from your lender. You are then free to use this money however you wish. So, let’s say you bought a house for $300,000 and you’ve paid off $70,000. You still owe $230,000 on the mortgage. Maybe you want to renovate your kitchen and bathrooms and it’s going to cost around $30,000.

If you want to use a cash-out refinance to pay for your renovations, you can add the amount of equity you want to borrow to what you currently owe on your mortgage for a new loan amount. In this case, that would be the $230,000 that you owe plus the $30,000 you need. Your new mortgage would be for $260,000 – the original $230,000 that you owed plus the $30,000 that you’ll receive as a lump sum after closing.

Applying for a cash-out refinance is similar to a traditional mortgage refinance, but you may also need at least 20% equity in your home to qualify. 

Cash-Out Refinance Calculator

A cash-out refinance calculator is a simple way to figure out how much you can borrow in a cash-out refinance. A calculator can also help you determine your new monthly mortgage payment after refinancing.

You may need to gather basic information, like your home’s current value, how much you owe on the mortgage, how much you would like to borrow and the loan term. You may also have the option to input additional factors that could affect the overall cost, like the interest rate, property taxes and other fees.

Or, you can try a calculator function similar to the one offered by Rocket Mortgage^®.

There are a few things to consider before getting a cash-out refinance. You will need to determine how much money you will need, the type of cash-out refinance, what interest rate you may qualify for, the terms of the loan and more.

How Much Cash You Need

Before applying for a cash-out refinance, it’s important to determine how much money you need. Additionally, there may be a limit on how much you can withdraw. Most types of cash-out refinances cap withdrawals at 80% of the equity you’ve built in your house.

Refinance Rates

Refinance rates will specify how much you pay in interest, which will cost you less over the life of the loan. For most homeowners, monthly payments typically increase after a cash-out refinance because you are borrowing more than you owe on the mortgage. But, if you are able to get a lower interest rate than you did when you applied for your first mortgage, your monthly payment could go down or remain the same.

Type Of Cash-Out Refinance Loan

There are several types of cash-out refinance options, and each type has its own rules and guidelines. Here are several cash-out refinance options:

• Conventional cash-out refinance: Fannie Mae and Freddie Mac set the rules for conventional home loans. The conventional cash-out refinance is typically used by homeowners with more than 20% equity built-up in their homes and a good credit score.
• VA cash-out refinance: The U.S. Department of Veterans Affairs offers VA cash-out refinances to active duty military service members, veterans, National Guard and Reserve members and qualifying surviving spouses. Members must meet certain service requirements and a VA cash-out allows homeowners to potentially borrow 100% of their home’s value.
• FHA cash-out refinance: The FHA cash-out refinance is backed by the Federal Housing Administration. FHA cash-out refinances tend to be less risky for lenders, but there are maximum loan amounts and you will need to pay mortgage insurance for 11 years.
• Jumbo cash-out refinance: If your new home loan will exceed Fannie Mae county loan limits, you may need to take out a jumbo cash-out refinance. Qualification requirements for jumbo loans are oftentimes more stringent than conventional loans.

New Loan Terms

When you take out a home loan, you and your lender will agree to a set of conditions that outlines what is expected of you over the life of your loan. Your loan terms specify the amount of time you have to pay off the mortgage. Loan terms vary, but 15-year and 30-year loans are the most common. The shorter your loan term, the higher your monthly payment may be. 

Closing Costs

Similar to a traditional refinance, there are closing costs associated with a cash-out refinance that could affect the total borrowing amount. Closing costs are typically between 2% – 3% of the principal on your mortgage. While a cash-out refinance can offer better interest rates, the closing costs can be higher.

Breakeven Point

The breakeven point refers to the point at which you save money on a refinance. You should calculate the breakeven point on your cash-out refinance so that you know you can recover the overall cost to refinance. You can do this by taking the total cost to refinance your home loan and dividing it by monthly savings if you refinance. This tells you the number of months it will take to breakeven.

Appraisal

Appraisals are required for a cash-out refinance. This provides your lender a professional opinion about what your home is currently worth. This tells you how much home equity you’ll be able to borrow against.

The cash-out refinance process is similar to a traditional refinance. To qualify, you must meet your lender's requirements and have a certain amount of equity in your home.

Cash-Out Refinance Requirements 

Here are the requirements and qualifications needed for a cash-out refinance.

• Credit score: Refinancing generally requires a credit score of at least 620 for a conventional loan. Other types of home loans may have different requirements. For example, a VA cash-out calls for a credit score of 580 or higher as long as you have at least 10% equity in the home after refinancing. You can take the full amount with a score of 620.
• Debt-to-income ratio: Most lenders want to see a debt-to-income (DTI) ratio of 43% or lower. You could qualify with a higher DTI using FHA or VA loans.
• Home equity: You’ll need to have at least 20% equity to do a cash-out refinance. However, VA loans allow some borrowers to refinance with no equity.
• Cash to cover closing costs: You need to have the funds to cover closing costs, which are typically between 2% – 3% of the principal on your mortgage.

There are plenty of reasons to refinance your home. A cash-out refinance is a great option for homeowners who have built some equity in their home and need to free up money for a financially beneficial purpose.

For example, if you owe money on student loans or are paying on other debts, you could use a cash-out refinance to pay off those debts and “transfer” the money to a place where the debt will accrue interest at a much lower rate – your mortgage. The interest rate on a credit card and other loans are often very high, sometimes above 20%, while your mortgage rate is likely less than 10%.

Cash-out refinances are also a good idea for homeowners that might need to make major home improvements or repairs – especially ones that increase home value like kitchen remodels, appliance upgrades, etc. If you just want to take out money to invest for your retirement or another upcoming cost, this may be a good option too.

Alternatives To A Cash-Out Refinance

If you’re looking for ways to make the most of your equity, refinancing isn’t your only option. Let’s go over a few other ways you can access the value you’ve built in your home.

• Home equity loan: A home equity loan, sometimes called a second mortgage, is a loan that uses the home equity you’ve built as collateral for financing. Unlike a cash-out refinance which ‘withdraws’ your equity and creates a new mortgage, a home equity loan is a loan separate from your mortgage which allows you to borrow an amount equal to a portion of your accumulated equity, which you’ll receive as a lump sum without withdrawing anything from your mortgage.
• Home equity line of credit (HELOC): A home equity line of credit, or HELOC, is a line of credit similar to a credit card that allows you to borrow against your home’s equity rather than a traditional credit limit. Like a home equity loan, it doesn’t “consume” your equity but instead uses it as collateral. This option might be a great choice for borrowers who need money but aren’t sure how much they’ll have to borrow yet and want the option to pay it back over time.

Below are some of the advantages and disadvantages of a cash-out refinance.

 The following are answers to frequently asked questions about cash-out refinancing.  

How much cash can I get from a cash-out refinance?

You can withdraw up to 80% of your home’s equity. However, a VA cash-out refinance allows borrowers to take 100%.

What can I use my cash-out refinance for?

You can use the funds from your cash-out refinance on anything you want. It’s typically recommended to use the extra cash for a financially beneficial purpose.

How much equity does a cash-out refinance require?

You need at least 20% equity in your home before refinancing. With a VA loan, you can potentially do a cash-out refinance with no equity.

Does a cash-out refinance affect my taxes?

The money you receive from a cash-out refinance isn’t free money or a capital gain, so there are no cash-out refinance tax implications. You don’t have to list the amount you cashed out on your taxes as taxable income.

Will a cash-out refinance lower my monthly payment?

This depends on your interest rate and the loan amount. Most homeowners generally see a higher monthly payment, but if you qualify for a lower interest rate than your original mortgage, your monthly payment could be lower.

Will a cash-out refinance impact my credit score? 

Yes, a cash-out refinance will impact your credit score. This happens not only because your lender does a hard inquiry while applying for the loan, but also because you are taking on a new loan.

A cash-out refinance is a way to use the hard-earned equity you’ve built up in your home for whatever you need it for – whether that be consolidating debt, renovations, or any other big cost that may come up in your life.

If you think you’re ready to refinance, you can get started on the application today.