What is cash-out refinancing and how does it work?

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Learn everything you need to know about cash-out refinancing and whether it could help you meet your financial goals. (iStock)

A cash-out refinance allows you to replace an existing mortgage with a new one that changes the repayment term, interest rate, or both, while also accessing your home’s equity. You can use the cash for anything, from funding home improvements to paying off higher-interest credit card debt.

But to qualify for a cash-out refinance, you’ll need to have sufficient equity in your home. Here’s a look at the types of cash-out refinancing loans, how much money you could get, how cash-out refinancing works, the costs, requirements, and other considerations.

If you’re thinking about refinancing, Credible lets you compare mortgage refinance rates from various lenders in minutes.

What is cash-out refinancing?

A cash-out refinance pays off and replaces your existing mortgage with a larger mortgage. Refinancing typically makes the most sense when your new mortgage will have a lower interest rate than you’re paying now. The difference between your new mortgage and old mortgage goes to you as cash, minus closing costs.

You don’t have to stick with your current lender to do a cash-out refinance. While you may want to get a quote from them, shopping around will help you get the best deal.

You can use the cash you get however you want. Many people borrow against their equity to pay for major home improvements, refinance debt, cover college tuition, or tackle other big expenses.

Types of cash-out refinancing loans

Cash-out refinance loans generally fall into one of three categories:

Conventional loans — You’ll need a credit score of at least 620 for a conventional cash-out refinance. Conventional loans are the most common and require an appraisal and income verification.
FHA loans — Most borrowers will need a minimum credit score of 580. You may not be able to cash out as much equity as you could with a conventional loan, and FHA mortgage insurance will be an additional cost.
VA loans — Eligible military service members and surviving spouses can cash out all their equity with a VA loan. These loans have no minimum credit score requirement, but most borrowers will pay an upfront funding fee at closing.

Good to know: With any of these loans, individual lenders may have their own, higher credit score requirements.

WHAT ARE THE DIFFERENT TYPES OF MORTGAGE LOANS AVAILABLE?

How does cash-out refinancing work?

Cash-out refinancing is similar to rate-and-term refinancing. The difference is that you’ll get cash back at closing in addition to a new interest rate, new loan term, or both. Follow these steps:

Calculate how much you need to borrow. It’s smart to only borrow as much as you need to accomplish your goal. If it’s a home renovation, get estimates from contractors (and add a buffer). If you’re paying off high-interest debt (like credit card debt), total up what you owe.
Shop around and compare lenders. Submit applications to several lenders, including your current lender. Getting multiple estimates will help you find the best deal.
Apply. Lenders will need to review documents that prove your income and assets. Be prepared with bank statements, tax returns, and W-2s.
Close on your new loan and pay off your original loan. Expect to get your cash and pay off your existing loan anywhere from 43 to 59 days after applying. Be sure to get confirmation in writing that your original loan has been paid off.

How much money can you get with cash-out refinancing?

This amount is different for everyone because it depends on how much your home is worth and how much you owe on your existing mortgage.

Here’s an example: Let’s say you have a mortgage balance of $170,000 and your home is appraised at $300,000. Your home equity is the difference between these two numbers: $130,000. Calculated as a percentage, your home equity is about 43%. Generally, lenders want borrowers to have at least 20% equity in their home in order to do a cash-out refinance.

Most lenders don’t allow borrowers to cash out 100% of the home’s equity, so you won’t be able to withdraw $130,000. Instead, lenders usually allow homeowners to borrow up to 80% of their equity. That means the maximum you could withdraw would be $104,000 (80% of $130,000). The balance on your new loan would be $274,000 — the balance of your old loan plus the amount you’re withdrawing as equity.

You can use Credible to compare mortgage refinance rates from various lenders without affecting your credit score.

How much does cash-out refinancing cost?

A cash-out refinance has closing costs just like a mortgage purchase or a standard refinance. Your closing costs will typically be 2% to 5% of the loan amount. These costs include mortgage origination fees, title insurance, a home appraisal, loan closing services, and more. Keep these costs in mind when calculating how much cash you’ll actually receive.

Example: You want to borrow $240,000 for a cash-out refinance. Expect to pay between $4,800 and $12,000 for closing costs.

A common way to pay closing costs with a cash-out refinance is to subtract them from your loan funds. Adding closing costs to your loan is a common practice with a purchase mortgage or traditional refinance, and you can do it with a cash-out refinance, too. But you’ll end up paying more interest over time because you’ll have to borrow more principal.

ARE MORTGAGE CLOSING COSTS TAX-DEDUCTIBLE?

What are the requirements for cash-out refinancing?

Lenders set their own requirements that borrowers must meet to qualify for a cash-out refinance. Here’s what they’re generally looking for:

A credit score of at least 620 — To get the best rates, aim for a score of 740 or higher.
A debt-to-income ratio (DTI) no higher than 50% — Again, you may get a better interest rate with a lower DTI.
Enough home equity to still have about 20% after cashing out — Lenders’ own guidelines and your financial profile will determine how much equity you can cash out.

Pros and cons of cash-out refinancing

Like any financial product, cash-out refinancing comes with pros and cons to consider.

Pros of cash-out refinancing

Reduce your interest rate — You may be able to borrow more money while securing a lower rate on your new home loan — and end up with a payment similar to the one you’re making now.
Pay down other debts — Paying off higher-interest-rate debts through a low-interest home loan can help you save money and build momentum toward financial security. But keep in mind that if you can’t make your new mortgage payments, you risk losing your home.
Protect your investment — One of the best ways to use home equity is to keep your home’s systems and structure in good condition.
Enjoy your home more — Renovations don’t always increase a home’s value. That said, if you’re spending lots of time in a space you don’t like, it may be worth borrowing to fix it up.

Cons of cash-out refinancing

Additional risk — Borrowing more could increase your risk of foreclosure or owing more than your home is worth. Also, your new monthly payment may be higher.
Slightly higher rate — Lenders may consider you a riskier borrower when you cash out some of your equity, so a cash-out refinance may cost more than a rate-and-term refinance.
Closing costs — If these costs are too high, a cash-out refinance may not be worthwhile.
Time to close — Waiting 30 to 60 days to close on a refinance might not cut it if you need money fast. Consider a personal loan instead.

When does cash-out refinancing make sense?

A cash-out refinance may be right for you if:

Your home has deferred maintenance. It’s important to protect your comfort and safety, as well as your home’s value.
You don’t want to move. A major renovation could adapt your home to changing needs with less expense or disruption than moving. Examples might include modifications for aging in place, an extra bedroom for a child, or an accessory dwelling unit for a relative.
You’re turning over a new leaf. If you use the cash to pay off credit cards and other high-interest debts — and don’t accumulate new high-interest debt — you may be able to save money and get a fresh start on stronger financial footing.

If a mortgage refinance is the right move for you, Credible lets you easily compare mortgage refinance rates from various lenders.

But a cash-out refinance may not be right for you if:

You already have a low rate. There have been many opportunities to get a great rate over the last 10 years, and especially over the last 20 months. Still, it’s worth doing the math and getting prequalified with lenders to see if you could save.
Your financial situation isn’t stable. Since life is unpredictable, it can be tricky to know when borrowing more money might improve your financial stability and when it might backfire.
Your credit score has taken a hit. You never know until you apply, but if your credit score is lower than it was when you got your current mortgage, you might not qualify for a low enough rate to make a cash-out refi beneficial.

Alternatives to cash-out refinancing

Besides a cash-out refinance, you may have other options to pay for large expenses.

Home equity loan — A home equity loan (also called a second mortgage) lets you cash out a significant amount of your home’s equity in a lump sum, but it allows you to keep your existing home loan. It can be a good option when you already have a great mortgage rate. It may carry a higher rate than a refi.
Home equity line of credit — A HELOC lets you access your home’s equity as needed instead of borrowing a lump sum. It’s another good alternative to a cash-out refi when you already like your mortgage rate. But with a HELOC’s variable interest rate, your monthly payments will be less predictable.
Personal loan — With excellent credit, a personal loan can have an interest rate similar to a mortgage or home equity loan. Closing costs are often minimal, and you won’t have to use your home (or anything) as collateral. But a shorter repayment term can mean substantially larger monthly payments compared to a home loan.