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.
Jump to cash-out refinance topics:
– How Does a Cash-Out Refinance Work?
– Should I Take Cash Out?
– Cash-Out Refinance Examples
– Reasons to Pull Cash Out?
– Cash-Out Refinance Rates
– How Much Can I Cash Out?
– Debt Consolidation Loan vs. Cash-Out Refinance
– Pros and Cons of a Cash-Out Refinance
– Cash-Out Refinance FAQ
– Cash-Out Refinance Tax Implications
How Does a Cash-Out Refinance Work?
- It works like a typical mortgage refinance in that you replace your existing home loan(s) with a new one
- But the loan balance will be larger thanks to the additional cash out portion requested
- This cash is extracted from your available home equity (difference between loan balance and property value)
- And can then be used for whatever purpose you choose such as to pay off other loans or renovate your home
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.
Once accessed, this cash can be deposited into your bank account and used for other expenses, such as funding home improvements, paying for college tuition, or paying off more expensive 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 original mortgage.
Do You Want Cash Out with That?
- If you apply for a mortgage refinance you will probably be asked if you want cash out
- This helps the lender determine what type of refinance you want/need
- And if so, how much you would like (they’ll tell you the max you can pull out)
- It’s totally optional and any cash you take must be paid back along with the original loan balance
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 (or bank account)!
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 home 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 a cold, hard lump sum of cash.
As noted, if you are able to snag a lower interest rate and get cash from your home, you’ve hit a home run! You’re saving money and you’ve got money in the bank.
Get a Cash Out Refinance or Open a Line of Credit (HELOC)?
- You may have the option to refinance your existing mortgage and pull out cash
- Or simply open a second mortgage behind it such as a HELOC or home equity loan
- This could make sense if you like the rate on your first mortgage and don’t want to mess with it
- You’ll also avoid restarting your loan term and slowing down your loan repayment
If you’ve got ample equity in your home, you’ve got multiple refinance 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.
Some Cash Out Refinance Examples to Help Illustrate
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 has a current market value of $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 (tied to the prime rate) 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 (down payment 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.
How Are Cash-Out Refinance Rates?
- There is a pricing adjustment for cash-out refinances
- They are more expensive than rate and term/home purchase loans
- How much more expensive depends on things like your credit score and LTV
- If you have a very high LTV and a very low credit score your cash out mortgage rate could be very high
They’re generally pretty similar to those of a home purchase or a rate and term refinance, though this can vary based on credit score, LTV, and so on.
Some borrowers may only see a mortgage rate .125% or .25% higher if they have excellent FICO scores and a low LTV.
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.
However, if you happen to have marginal or poor credit, your interest rate could skyrocket if you’re taking cash out. Same goes for a high-LTV loan, and even worse if you combine the two!
Also note that a refinance with cash out will obviously be larger, so that can drive the monthly payment higher as well compared to your original home financing.
Cash-Out Refinance vs. Debt Consolidation Loan
As mentioned, some homeowners will utilize a cash-out refinance as a debt consolidation loan.
But instead of simply tapping equity and putting the proceeds in their bank account, they pay off existing debts at closing.
So in essence, it works in opposite fashion because the borrower isn’t taking on additional debt. They are reducing the cost of existing debt via the refinance.
For example, imagine a homeowner with $30,000 in credit card debt and another $20,000 in personal loans, with respective APRs of 20% and 12%.
The borrower elects to refinance their mortgage and pull $50,000 out on top of their outstanding balance to pay off that $50,000 in non-housing debt.
While they pulled cash out of their home, they didn’t increase their total outstanding debt. They paid it off and consolidated those existing balances into their mortgage.
These balances are often paid off via proceeds from escrow at closing so the borrower doesn’t actually receive cash in hand.
In the process, they also reduce the cost of their debt, because their hypothetical mortgage rate might be 6% versus the 12-20% on their old loans.
How does this differ from a standard cash-out refinance? Well, that would imply taking on additional debt that the borrower didn’t have prior.
An example being a kitchen remodel, where they now have another $50,000 in debt on top of their old mortgage and any other non-housing debt.
So while a debt consolidation loan is very similar to a cash out refinance, and largely the same process, there are some key differences.
For the record, you could also just get cash out proceeds via the refinance deposited into your bank account and then pay down your other debts on your own.
Pros and Cons of a Cash-Out Refinance
- A relatively simple way to access the equity in your home (via a traditional mortgage)
- May be able to pull out a lot of money depending on property value and outstanding balances
- Could be much cheaper to borrow versus alternatives if mortgage rates are favorable
- Might be tax deductible if used for qualifying purposes such as home improvements
- Long repayment period makes for manageable monthly payments (often up to 30 years)
- Fixed payments that don’t change if you choose a 15- or 30-year fixed mortgage
- Have to go through the mortgage process (again!)
- Larger loan balance means higher payments and more interest paid
- Will restart your amortization schedule unless you choose a shorter term
- You lose your existing mortgage rate (assuming it’s a low one you want to keep)
- Have to pay closing costs like you would a normal mortgage
- Might be restricted to how much you can borrow (low LTV limits)
- May require a higher credit score to obtain financing
- Seasoning requirements may not allow it for X amount of time after purchase
Cash-Out Refinance Frequently Asked Questions:
Now let’s tackle some questions you may have (or may not even realize to ask) about cash out refinances.
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 bag.
Do I lose home equity after refinancing?
You don’t lose it, you use it! And as a result, you have less available home equity because it has now been tapped.
For example, if you owe $200,000 on a $600,000 property and cash out an additional $100,000, you’ve now only got $300,000 in available equity instead of $400,000.
But that money is now yours to do with as you please.
How much can I cash out refinance?
After considering the max LTV allowed by your lender, you need to determine your property’s current appraised value and outstanding loan balance.
Your borrowing may also be restricted by DTI limits if the new, larger loan balance creates a monthly payment that is too high for your income.
For example, say your home is worth $500,000 and you have an outstanding loan balance of $300,000. If the lender allows a max LTV of 85%, you could potentially take out a loan amount of $425,000.
But the lender would have to verify that you could handle monthly payments on that larger $425,000 loan amount as well.
So max cash out will be determined by both LTV and borrower affordability.
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.
This logic applies to all types of mortgages, but can be especially impactful on cash out refinances because the pricing adjustments are often higher.
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 second mortgage.
For example, if you open a HELOC or home equity loan behind your existing first mortgage after the original purchase transaction and then later want to refinance both loans, 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?
POSSIBLY. So we know the cash out isn’t treated as income. But even better, it may be tax deductible, though there are limits of indebtedness of $750,000 ($375,000 if married filing separately).
Additionally, regardless of when the indebtedness was incurred, you can generally only deduct the interest if it was used to buy, build, or substantially improve your home.
In other words, if the cash was used to fund a home improvement such as a new bathroom or kitchen renovation in your qualified main or second home it might be deductible if you itemize.
But those paying off non-housing related debt such as student loans or credit cards with cash out proceeds likely wouldn’t qualify for a tax deduction.
This is covered in IRS Publication 936, though still somewhat confusing to interpret, especially in light of the Tax Cuts and Jobs Act of 2017. Tax situations vary so consultation with a CPA may be advisable.
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.
Is cash out allowed on a streamline refinance?
No, streamline refinances are only intended to help borrowers lower their monthly mortgage payments and/or move from an adjustable-rate product to a fixed-rate product. A cashout loan wouldn’t accomplish that saving money part.
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.
Any bank, credit union, or mortgage bank should offer these refinance options.
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, if you constantly take cash from your home, 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 cash out 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!