What Is a Cash-Out Refinance?

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 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.

[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:

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!

Tip: When to refinance a mortgage.



145 Comments

  1. Michele November 28, 2017 at 9:05 pm - Reply

    Hi, we are in the process of doing a cash out refi. The home value came in at 204k we owe 151k they are offering a new mortgage of 171 closing cost are looking like 7k which seems high to me it’s a fha loan. I feel like we should shop around more . Also we first tried for a home equity line but were declined because they did a drive by appraisal which only came in at 189k can we use this appraisal we just got from the mortgage company to try for the cash out refi ? Thanks

    • Colin Robertson November 29, 2017 at 9:41 am - Reply

      Michele,

      If you don’t like the costs, shopping around should give you a better idea of what’s reasonable. As far as the appraisal goes, you can request that a new FHA lender you work with use the old one. Have you looked into conventional options? Is there a reason you’re going FHA and also keeping your LTV above 80%? Pricing might be more favorable if loan is kept at 80% or less, and you can also avoid mortgage insurance if you go conventional.

  2. D October 30, 2017 at 4:07 pm - Reply

    We purchased our home a little over a year ago and the loan balance is now 270,000 but the market value is 310….we were told by the guy who does our mortgage that we have to wait until the home is valued at 350-360 before we can refi …this doesnt seem to make sense to me that our home would have to go up in value by more than 60k before we can refi…does this make sense?

    • Colin Robertson October 31, 2017 at 7:56 am - Reply

      D,

      It sounds like your guy wants the loan-to-value on the refinance to be under 80%, whereas it currently stands around 90% based on the $310k valuation. That can make it more difficult to qualify for a refinance, or to at least make one worthwhile depending on what your interest rate is now and what you’re attempting to do. You can ask for clarification and options based on the home’s current value so you fully understand the situation.

  3. joewayne roqueta October 17, 2017 at 6:23 pm - Reply

    hey…question: im planning to do cash out refi and spoke to 1 bank; my house market value is $475.000, i owe 252.000, planning to get $100.000, the guy i spoke to told me the “estimate loan amount” is 355.000,,,here is my question:
    $475.000 – market value
    – $100.000 – cash out
    = $375.000 – after cash out
    if the loan amount is $355.000 where is the $20.000 go?
    thanks guys

    • Colin Robertson October 18, 2017 at 7:10 am - Reply

      You seem to be doing the math in reverse based on the value, not the outstanding balance. If the current balance is around $252k, add $100k to that and it’s around $352k, then the bank rounded up a bit to perhaps cover closing costs, making it $355k.

  4. Judy July 26, 2017 at 8:48 pm - Reply

    The underwriter wants me to write a letter explaining what I’m doing with the cashout refinance. I have excellent credit, a stable job that pays well, owe less than $10k on my home, the appraisal same in $20k higher than I estimated, and I’m only asking for 80% LTV. I thought I could do whateverI wanted with the money. I did not have to explain the last loan 9 years ago when I was not as financially stable. Why now?

    • Colin Robertson July 27, 2017 at 7:47 am - Reply

      Judy,

      It’s a typical condition where they ask what you’ll do with the cash proceeds, e.g. to fund home improvements, to set aside liquid reserves, etc.

  5. Megan Y May 30, 2017 at 10:16 am - Reply

    Hi Colin,

    We own a home outright that we want to sell but we need to get cash out to make some improvements before that can happen. We can’t get a home equity loan due to low credit scores, so looking at possibility of cash out refi. Do you know if there are any rules or penalties around how quickly one can pay off their cash out refi? Plan would be to pay it off as soon as we can sell the home.

    Thanks in advance!
    Megan

    • Colin Robertson May 30, 2017 at 2:13 pm - Reply

      Megan,

      There are no longer prepayment penalties on most mortgages so early payoff likely won’t be an issue. However, a loan officer may tell you 3-6 months because loans that are paid off too fast can result in a commission clawback for the originator.

Leave A Response