Let’s talk mortgage basics. There are two main types of mortgage refinances available to homeowners. There is the standard rate and term refinance, which allows a borrower to obtain a lower mortgage rate and/or shorten their loan term, while keeping their existing loan balance intact. And then there is the “cash-out refinance,” which allows a borrower to tap into the equity (or cash) in their home.
Put simply, if you’ve paid down your current mortgage balance and/or home prices have increased since purchase, you may have equity in your home that you can access via cashout refinancing to use for other expenses, such as funding home improvements, paying for college tuition, or paying off credit cards.
With today’s mortgage rates so attractive, it might be possible to refinance your mortgage, get cash out, and obtain a lower interest rate, all in one transaction. This might be especially true if the value of your home has increased significantly since you took out your purchase mortgage.
Let’s learn more about what a cashout refi is, the pros and cons, and how this loan option can quickly replenish your savings account to pay for other bills.
How does a cash-out refinance work?
When mortgage refinancing, if a borrower elects to take “cash out” in addition to changing the rate and term of their existing home loan, the new mortgage balance will be larger than the original. That’s right, these funds don’t appear out of thin air, nor is it free money, even though you get cash in hand!
I kind of liken this to the old line, “Do you want fries with that?” But instead, it’s, “Do you want cash out with your refinance?”
In short, you’re taking out a larger loan when you execute a cash out refinance, which means monthly payments will likely be higher. You can use my mortgage payment calculator to see how much more you’ll pay each month.
Once the refinance loan is complete, the new loan will consist of the original balance prior to the refinance plus the desired cash out amount, less closing costs. So expect both the size of your mortgage and your mortgage payment (depending on interest rates) to increase in return for cold, hard cash.
As noted, if you are able to snag a lower interest rate and get cash, you’ve hit a home run! You’re saving money and you’ve got money in the bank.
Refinance your Mortgage or Open a Line of Credit (HELOC)
If you’ve got ample equity in your home, you’ve got multiple refinancing options at your disposal, along with another loan type that won’t disrupt your loan term and payoff goals.
There are essentially two main ways a borrower can tap into their home equity.
They can either open up a home equity loan or home equity line of credit, also known as a HELOC, behind their existing first mortgage, or refinance their current mortgage(s) and take cash out in the process.
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 home equity loan) 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 current loan. 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 an additional $100,000 cash out, creating a new $400,000 mortgage.
The amount of equity and cash to the borrower are the same in this scenario as in the first example.
The only difference is that the homeowner still has a single home loan, as opposed to two mortgage loans, although it’s a completely new mortgage with a brand new term and possibly a new interest rate, quite likely with a different bank or mortgage lender.
So which approach works best? There are pros and cons and it really depends on the borrower. 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 loan 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. In any case, there are refinance calculators out there to aid you in your decision.
Why do people pull cash out of their homes?
• Home improvements
• Other investments (stocks, bonds, etc.)
• Vacations and other luxuries
• College tuition
• Home buying (to purchase another property)
• To pay-off other higher-interest-rate debt, such as credit cards or auto loans
• Pay off student loans or a personal loan
• For an emergency (buffer their checking account)
• Because they want cash for any number of reasons
There are countless reasons to refinance depending on your financial goals.
While a rate and term refinance can be helpful to lower your monthly payments and/or drop mortgage insurance, cash out refinance loans are good for, well, getting cash.
Many homeowners use cash-out refinances for debt consolidation, home improvement, or for future investments. To avoid paying high-interest rate credit card debt, 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. And consider a balance transfer instead if it’s just credit cards, you might be able to get 0% APR for a lengthy period of time.
Other homeowners may pull cash out to make improvements to their home that will increase the market 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 refinance with cash out will obviously be larger, so that can drive the payment higher as well compared to your original home financing.
Like a purchase mortgage, both fixed rates and adjustable-rate loan options are available on a cashout refi.
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 real estate, 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 zapping the equity.
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 refinance loans 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 loan 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.
Can you get cash out with VA loans?
Yes, as long as you occupy the property as your primary residence. And it may be possible to get up to 100% LTV financing depending on the circumstances. Additionally, you can use a VA cash out refi to refinance a non-VA loan (FHA loan, USDA loan, conventional loans) into a VA loan.
Is cashout refinancing allowed on jumbo loans?
Absolutely! It’s possible to get cash out with your jumbo loan, and the loan limits might be much higher than other loan options. The downside is the max LTV might be lower to compensate for risk, so you’ll probably need a fairly large equity cushion.
Where can I get a cash out refinance?
Pretty much any financial institution that offers home loans will also offer cash out refinances. There aren’t really so-called refinance lenders per se, though there are certainly lenders whose volume consists mainly of refinances as opposed to purchase mortgages.
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) and run the numbers through a mortgage calculator before making a decision!