What Is a Cash-Out Refinance?

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 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.

[How does refinancing work?]

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:

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.

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!

Tip: When to refinance a mortgage.

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37 Comments

  1. Sherman July 8, 2013 at 2:12 pm -

    How much higher are mortgage rates for a cash-out refinance? Just curious if it’s worth tapping some equity.

  2. Colin Robertson July 9, 2013 at 8:56 pm -

    Sherman,

    It depends…there may be no hit for cash-out at a certain loan-to-value (LTV) or with a certain lender. However, the higher your LTV, the bigger the hit (and restriction) for taking cash out. Just shop around and see what’s out there.

  3. Roy July 12, 2013 at 9:32 pm -

    People using their homes as ATM machines and taking cash out is what caused this crisis. The banks should be more responsible and not let homeowners just continuously pull equity without any consequence. They should limit LTVs for cash out loans to some really low number where it will never be an issue.

  4. Demi July 14, 2013 at 11:27 am -

    I refinanced recently, and the pricing was the same whether or not I took any cash out, but I have a ton of equity in my home. I was looking at a LTV of 60% or less depending on if I took cash out or not. But I think for LTVs over 65-70%, they start adding pricing adjustments. But if you need the money, you have to pay the price.

  5. Laura July 22, 2013 at 3:22 am -

    Does anyone know of a lender that will allow cash-out above 90% LTV? I need to refinance, but I can’t find a bank willing to go that high.

  6. Zack July 23, 2013 at 2:26 am -

    After home prices increased, I wanted to cash out some of my home equity, but all the lenders I’ve spoken with say the max LTV is 80%. So in reality, even though I am not underwater anymore, I can’t actually use the money in my home. This is nonsense.

  7. Lavonda August 21, 2013 at 5:06 pm -

    There’s a reason banks aren’t allowing high LTVs on cash-out refis…they don’t want to repeat the same crisis all over again, especially if home prices don’t hold up this time around. These types of loans were the reason homeowners got underwater in the first place.

  8. Kevin September 14, 2013 at 8:04 pm -

    Just be patient folks. Now that the refinancing boom has died off, lenders will ease guidelines to ramp up business. Expect higher LTVs on cash-out loans in the near future.

  9. Toney February 18, 2014 at 5:52 pm -

    What is the max LTV for cash out on an investment property? It is a single-family residence.

  10. Colin Robertson February 19, 2014 at 5:18 pm -

    Toney,

    You’re probably looking at a max LTV of 80% when pulling cash out on an investment property. Some lenders might be lower/higher than that number, but the days of 90-100% cash out are behind us.

  11. Shawn March 5, 2014 at 9:14 am -

    So it occurred to me that you receive money when you do a cash out refinance. That being said, is a cash out refinance taxable? Does the government want you to pay taxes in the year you completed the refinance?

  12. Colin Robertson March 7, 2014 at 10:21 am -

    No, a cash out refinance is NOT taxable, but it can be tax deductible, just like other mortgage debt. In other words, when you pull cash out of your home, you’re simply tapping existing home equity and creating debt, so it’s not “income” in the pure sense. It’s creating liquidity, but with a loan attached, as opposed to just receiving money scot-free. And because it’s new mortgage debt, it may be deductible up to a certain amount as well. So you could actually get some tax relief via a cash out refi.

  13. S March 23, 2014 at 2:24 pm -

    Colin, thanks for information. As to the reference in above post, you note that there is 80% LTV possible on residential investment property. I talked to mortgage broker about this and they say on investment properties one could not expect more than 70& LTV. Do you any lenders who do the 80% LTV for single family investment properties. Thanks

  14. Colin Robertson March 23, 2014 at 3:33 pm -

    Hey S,

    I originally wrote this back when such an LTV was possible, and it could well be again in the near future as lenders react to falling refinancing volume by loosening guidelines. Speak to several brokers, banks, and credit unions to see if anyone will go as high as 80%. One broker may not work with the bank that offers such financing, but another might, assuming it’s out there.

  15. Anthony March 28, 2014 at 2:36 pm -

    Colin,

    last month I got my name on title. The loan is $40K on the house and want to pull some cash out to put money back in my pocket after remodel. House appraised at $155K. Are there any lenders out there that would help pull $ 50K out?

  16. Colin Robertson March 28, 2014 at 3:23 pm -

    Typically you need to be on title for at least six months before pulling any cash out, but there might be lenders out there willing to work with you, though they may charge a higher interest rate for that convenience.

  17. Sean April 1, 2014 at 7:40 am -

    I own my house outright…no mortgage. I want to demolish my existing house and build a new one in its place. The cost to build the new house is $70K more than the existing house is worth. Can I do a cash-out for the value of my house plus the extra $70K, demolish the existing house and build the new one using the cash-out loan? Is this illegal?

  18. Colin Robertson April 1, 2014 at 10:29 am -

    This sounds more like a construction loan situation. If a lender provided cash out, they would be extending financing based on their interest in the existing structure, which if knocked down, changes the entire picture.

  19. Sean April 1, 2014 at 11:34 am -

    Colin, thanks for the reply. That’s the sense I was getting but is it illegal to do it? I know it’s probably unethical to do but would there be legal ramifications if I decided to do it? Do you know? Thanks.

  20. Colin Robertson April 1, 2014 at 12:17 pm -

    Not sure about legality, but the lender might be able to call the mortgage due if you tear it down.

  21. Sean April 2, 2014 at 11:41 am -

    Gotcha. OK, thanks for the info Colin. Appreciate the help.

  22. maria May 27, 2014 at 12:51 pm -

    What’s the latest on cash out refinances with regard to the borrowers other existing debt?
    I hear for VA/FHA loans existing credit cards need to be paid off (which would be fine) but also CLOSED??

  23. Colin Robertson May 27, 2014 at 3:19 pm -

    Maria,

    I haven’t heard that. Are you talking about credit card accounts that are in collection status? Not sure why a lender would have you close an account that can be easily reopened after receiving your loan.

  24. Nancy Imbrescio May 28, 2014 at 12:15 pm -

    looking to take a HEL or cash out refinance.. but, I’ve only got 5 more years on mortgage (at 5.75%) and I need to take out 35,000 to pay off student loans for son. (doing this only because I think the interest is will be better than Sallie Mae, etc..).. not sure I want to refinance my 1st mortgage

  25. Colin Robertson May 28, 2014 at 12:51 pm -

    Nancy,

    If you’ve only got 5 years left on the loan, the majority of the payment each month is going toward principal (since you already paid most of the interest due) so you might want to look at the equity line/second mortgage route as an alternative.

  26. Kenneth Powell June 2, 2014 at 5:11 pm -

    Mr. Robertson.
    I have currently own a home that I have lived in for over 2 years, with no mortgage. (paid cash 4 ) Value 180,000/200,000. Problem is credit scores r 640 / 613 . I would need to pull 50,000. out. Qualified with good ratios. Need to pay property taxes & a IRS Lien (3500.00) and kid’s student loans. Is there any HOPE, or sell the home that I grew up in,
    Thank you
    (I hope that you have a solution for my problem.

  27. Colin Robertson June 2, 2014 at 7:25 pm -

    Kenneth,

    I’m assuming you have three credit scores but I don’t what they all are. They use the midscore so you might be OK. There’s certainly hope because your LTV will be very low, around 25% or so, though you might want to work on improving your credit scores a bit before applying to get a more favorable interest rate and to expand your available lender options. That’s if you have some time, otherwise you might have to accept less favorable terms.

  28. Dee June 23, 2014 at 9:36 am -

    I built my home 5 years ago. It is appraised at 375,000, I owe 210,000. However, over the last 2 years, our income has gradually declined and now 3 months ago, my husband lost his job of 26 years because it closed. Although he has another job now, we are still limited on the income. I’m wondering if theres anyone who does a HELOC to pay off all other debt and focus on mortgage, or should I do a Loan modification that I keep getting calls to do?

  29. Lourdes August 29, 2014 at 6:23 pm -

    Mr. Robertson,
    We refinanced a few times with a total of $150K cash out. $50K of that was in 2013. The way I understand is that over $100K needs to be for home improvement.

    How long do we have to prove the IRS for home improvements with the $50K before having to pay taxes?

    We are not planning to sell our home for a long time. And of course we did the cash out without knowing the tax implications until recently.
    Do we show the $50K as income in the 2013 tax report?
    Thank you

  30. Colin Robertson September 2, 2014 at 12:40 pm -

    Lourdes,

    It sounds like you’re referring to the deductibility of the mortgage interest. A loan isn’t income, it’s a loan. But you need to contact your tax preparer or CPA to sort it out.

  31. Lourdes September 3, 2014 at 6:51 am -

    Mr. Robertson,
    Yes, we will get a CPA to make sure what are our options.
    thanks for your prompt reply.

  32. Gloria September 7, 2014 at 11:24 pm -

    Hi Mr. Robertson,
    We are in the process of refinancing our home for $200,000. Our first mortgage has a balance of $57,000 @5% which will be paid off June, 2016 and a heloc equity loan of $97,500. Our home appraised for $774,000. The problem is, we co-signed on our son’s condo which is added to our debt, so our debt to income ratio is high. The mortgage Co. we are working with now wants to pay off our 2 mortgages and our 2 car loans and give us what ever is left out of $200,000 for bathroom improvements. Is it better to pay off our car loans from our savings/401K/Roth IRA?

  33. Colin Robertson September 8, 2014 at 8:52 am -

    Gloria,

    If you use the cash out to pay everything off, you can always pay down your low-rate mortgage (whenever you want) using savings or other cash. So in a sense it gives you more flexibility. But that’s your decision.

  34. Amanda October 6, 2014 at 10:01 am -

    We have a first mortgage of 20,000. that will be paid off 3/16 and a second mortgage line of credit. Currently we owe 50,000. on the second. The home is valued at 450,00. and we want to do a cash out for 120,000.00 which will bring the combined mortgages to around 200,000.00 (including the cash out).
    That being said we have an old 401k worth 135,000. that we have thought about cashing out (realize the penalties and taxes). We have a new 401k that we max out in donating too and a retirement plan that we pay into, not to mention we are also part owners in the company. We are in our late 40’s.
    So the question is which is best a refi or to take the old 401k?

  35. Colin Robertson October 6, 2014 at 10:28 am -

    Amanda,

    You’ll have to do the math and look at the implications of both and your financial/retirement goals to determine what’s best for your particular situation. I assume most financial advisors don’t recommend pulling from a 401k early, but to each their own. Also, mortgage rates are still pretty darn low, so that could sway a decision.

  36. Al October 13, 2014 at 5:22 pm -

    I have just completed a home improvement work using a low interest credit line for over $100K, if I refinance this credit line with cash out will it all be tax deductible (even if the home improvement has been completed at the time of the cash out)? In other words, is there any timing restriction for the home improvement work wrt cash out time.

    Thank You

  37. Colin Robertson October 13, 2014 at 9:39 pm -

    Al,

    You can deduct mortgage interest as you pay it. If you refinance you’re not paying interest, you’re just replacing one loan with a new loan and paying interest on that loan eventually. But consult your tax man.

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