There are two main types of mortgage refinances. There is the standard rate and term refinance, which allows a borrower to snag a lower mortgage rate and/or shorten their term, while keeping their existing balance intact. And then there is the “cash-out refinance,” which allows a borrower to tap into the equity in their home.
How does a cash-out refinance work?
When refinancing, if a borrower elects to take “cash out” in addition to their existing loan, the new mortgage balance will be larger than the original. That’s right, it’s not free money, even though you get cash in hand!
Once the refinance is complete, the new loan will consist of the original balance prior to the refinance plus the desired cash-out amount. So expect both the size of your mortgage and your mortgage payment to increase in return for cold, hard cash.
There are two ways a borrower can tap into their home equity. They can either open up a home equity line of credit, also known as a HELOC, behind their existing first mortgage, or refinance their existing mortgage(s) and take cash out.
Let’s look at an example where a homeowner wishes to get $100,000 cash-out of their home:
Home value: $500,000
Existing liens: $300,000 (fancy way of saying current loan balance)
Home equity: $200,000
In the above example, the homeowner has an existing mortgage balance of $300,000. The home is currently worth $500,000, so the homeowner has $200,000 in home equity. In other words, the homeowner essentially owns $200,000 of their home, or 40% of the current property value. As mentioned, if the homeowner wishes to tap into that equity, they can either get a second mortgage (HELOC) or execute a cash-out refinance.
Let’s assume the homeowner opts to add a second mortgage via a HELOC:
Home value: $500,000
Existing liens: $300,000
HELOC: $100,000 (behind the 1st mortgage)
Home equity: $100,000
In the above example, the homeowner adds a second mortgage behind their existing $300,000 first mortgage. The $100,000 home equity line they added increases their existing loan balance to $400,000, and subsequently lowers the equity in their home to $100,000. But the homeowner now has a $100,000 credit line to use for whatever they wish, without changing the rate or term of the existing first mortgage. This is NOT a cash-out refinance.
Now let’s assume they execute a cash-out refinance by refinancing their existing loan and adding cash-out:
Home value: $500,000
Existing liens: $300,000
Cash-out refinance: $400,000 ($400,000 new 1st mortgage, no 2nd mortgage, $100k cash goes to borrower)
Home equity: $100,000
In this example, the homeowner refinances their original $300,000 mortgage and takes $100,000 cash out, creating a new $400,000 mortgage. The amount of equity and cash to the borrower are the same in this example. The only difference is that the homeowner still has a single loan, although a completely new mortgage with a fresh term and possibly a new interest rate, quite likely with a different bank or mortgage lender.
So which approach works best? When looking to execute a cash-out refinance, it’s important to decide which method makes sense for your unique financial situation. If interest rates are low at the time you’re looking to cash-out, you may want to refinance your existing mortgage and consolidate the old mortgage and cash-out into a single loan as we saw in the last example.
If mortgage rates aren’t favorable but you still need cash, it’d probably be best to leave your first mortgage alone and add a second mortgage behind it. That way it won’t affect the interest rate of the first mortgage.
Things like remaining term must also be taken into account. If your mortgage is close to being paid off, it may be wise to leave it untouched and opt for pulling cash out via a second mortgage. But if your mortgage is new and the interest rate is not all that favorable (or adjustable), it might make more sense to refinance the whole kit and caboodle.
Why do people pull cash out of their homes?
• Home improvements
• Other investments (stocks, bonds, etc.)
• Vacations and other luxuries
• College tuition
• To purchase another property
• To pay-off other higher-interest-rate debt, such as credit cards or auto loans
• For an emergency
• Because they want cash for any number of reasons
Many homeowners use cash-out refinances for debt consolidation, home improvement, or for future investments. To avoid paying high-interest rate credit cards, homeowners may use cash out to pay off those bills. Instead of paying a 20% interest rate or higher on a credit card each month, you can pay off that balance using your mortgage and pay a rate of 5-8% instead. Just realize the risk involved if you fail to make your mortgage payments.
Other homeowners may pull cash-out to make improvements to their home that will increase the value significantly, which over time can lower their loan-to-value ratio and increase the equity in their home.
Others may pull cash-out if they feel they can invest the money at a better rate of return than the mortgage rate.
The question you need to ask yourself is whether it makes sense financially to refinance your current mortgage to take advantage of anything mentioned above. Keep in mind that there are fees associated with taking out a second mortgage, and even more if you plan on refinancing your first mortgage and taking cash-out.
While a cash-out refinance can provide homeowners with much needed help in a dire situation, when you cash-out, you essentially reset the mortgage clock and lose all the equity you’ve spent years building. Not only do you lose your equity, but you also take on more debt.
Cash-out refinance Q&A:
How are cash-out refinance rates?
They’re generally pretty similar to those of a purchase or a rate and term, though you might expect your mortgage rate to be an .125% or .25% higher. In other words, if the rate were 3.625% without cash out, expect the cash out refinance rate to be 3.75% or 3.875%, all else being equal.
Depending on the loan amount, that can amount to a few extra bucks or $100 or more per month. Also note that a loan with cash out will obviously be larger, so that can drive the payment higher as well.
What is the seasoning requirement for a cash-out refinance?
Most lenders will not let homeowners take cash-out on their property without 12-months seasoning. Meaning that if you buy a property, you’ll need to sit on it for at least a year before taking any cash-out. Lenders enacted tougher cash-out rules to deter investors from buying homes with zero money down, and quickly refinancing them at a higher value and taking cash out.
There are some lenders that will allow cash-out up to 75% loan-to-value without any property seasoning, but most homeowners who are looking for quick cash-out usually do not have 25% equity in their homes.
What is the max LTV for a cash-out refinance?
Seasoning aside, there are typically strict limits on how much cash out you can take. At the moment, most lenders allow a max LTV of 85% for cash-out refinances. In the “good old days,” you could get cash-out at 100% LTV, meaning you could take out a loan for the full value of your property. Clearly this didn’t go well once home prices plummeted and lenders were stuck holding the ball.
Can I do a cash-out refinance with bad credit?
It depends how low your credit score is. You can generally get approved with a credit score as low as 620, which many would consider bad or close to bad. Of course, your interest rate will be higher to compensate, so it’s often in your best interest to improve your scores before applying unless you really need the cash.
Is my refinance considered rate and term or cash-out?
Another important note is that a refinance will be likely be considered cash-out if a borrower refinances a non-purchase money home equity line of credit. That is, if you open an equity line behind your existing first mortgage after the original purchase transaction and then later want to refinance it, it will be treated as a cash-out transaction even if you aren’t taking cash-out at that time. What this may mean to the homeowner is another pricing adjustment when they refinance, which will result in a higher interest rate. It’s not the end of the world, but something to consider.
Many borrowers also feel if they aren’t getting cash in their pocket, their refinance isn’t considered cash-out. This is false. If you pay off credit cards or auto loans and receive zero cash in hand, the bank or lender will still consider it cash-out, and it will be underwritten as such.
Is a cash-out refinance taxable?
NO. As mentioned, you aren’t getting free money via the refinance transaction. You are taking out a new loan with a larger balance and you must pay it back (with interest) over time. So there’s no income tax to worry about. However, you’ll likely have larger monthly mortgage payments to contend with.
Is a cash-out refinance tax deductible?
YES. So we know the cash out isn’t treated as income. But even better, it’s tax deductible, though there are limits of $100,000 ($50,000 if married filing separately). So if you pull $150,000 cash out, only the first $100,000 is fully tax deductible.
However, if $50,000 of that amount is used to improve your home (a new bathroom, kitchen renovation), that portion would be deductible via your “Home Acquisition Debt” and the remaining $100,000 would be deductible under your “Home Equity Debt.” So you could deduct everything, assuming you stay under the separate limits on the “Home Acquisition Debt” and otherwise qualify per the many IRS tax rules. Speak with your CPA to be sure.
Can I get a cash-out refinance on a rental property?
Yes, though the LTV limits could be significantly lower. We know the max LTV is around 80-85% for primary residences. For rental properties, aka investment properties, you might be looking at a max LTV of 70-75%, or lower. So keep that in mind before thinking you can tap all that equity!
Can you do a cash-out refinance with an FHA loan?
Yes, though the LTV limits are again restricted. For FHA loans, the max LTV for a cash-out refinance is 85%, down from 95% before the mortgage crisis. HUD lowered the max LTV as a result of deteriorating conditions in the housing market. In other words, if home prices keep dropping and they continue to offer cash out up to 95% LTV, they’ll lose their shirt.
Will a cash-out refinance take longer to pay back?
With any mortgage refinance, it is important to understand the costs involved and the underlying motivation. You should avoid serially refinancing your mortgage if at all possible. Aside from the associated costs, you will set yourself back in paying off your mortgage, and wind up paying more interest than if you simply left the mortgage alone.
You could also land yourself in a negative equity position. That’s why a refinance should really only be reserved for times of great need, or in times when rates are simply too good to pass up. Do your homework (lots of it) before making a decision!