When you’re a homeowner and you pay your mortgage, you build equity in your home over time as your principal balance decreases and your home goes up in market value. In some cases, you may decide to access that equity with a cash-out refinance.
A cash-out refinance allows you to take out a new, larger mortgage loan to pay off your existing mortgage and pocket the difference to use for other purposes. Because a cash-out refinance carries some risk — like losing your home to foreclosure if you can’t afford the higher mortgage payments — you need to decide if it’s worth it in the long run based on your overall financial goals.
On this page:
- What Is a Cash-Out Refinance?
- Benefits of a Cash-Out Refinance
- Downsides of a Cash-Out Refinance
- How Does a Cash-Out Refinance Work?
- Cash-Out Refinance Rates
- Should I Choose a Home Equity Loan Instead?
What Is a Cash-Out Refinance?
A cash-out refinance involves taking a new mortgage loan in excess of your current mortgage balance. For example, if you owe $150,000 on your mortgage, you could take out a new $200,000 mortgage, depending on your home’s value and the equity you have built up. You’d use $150,000 to pay off your existing mortgage and keep the rest.
Cash-out refinances can be used for many things, including:
- Home improvements
- Debt consolidation
- College tuition
- A down payment on a second home or home for your child
- Other major purchases
Any time you want to put access your home equity to use the funds for other things, a cash-out refinance could be the solution.
Benefits of a Cash-Out Refinance
There are many potential benefits of a cash-out refinance, including:
- Competitive interest rates: Since the new loan is secured by collateral (in this case, your home), you will likely receive a competitive interest rate. Mortgage loans tend to have much lower rates than credit cards, personal loans, and other consumer debt.
- Lower interest rates than home equity loans or home equity lines of credit: You could also access the equity in your home by taking a home equity loan or a home equity line of credit (HELOC). However, both loan products tend to have higher interest rates than a primary mortgage — which is what you’d have if you took out a new mortgage for a cash-out refi.
- Convenience: If you opt for a cash-out refi, you’ll have just one loan to pay, whereas if you took out a home equity loan or home equity line of credit, you’d have multiple monthly payments.
- Tax deductibility: If you itemize on your taxes, you can take a deduction for interest on mortgages up to $750,000 in value (for home loans taken out after December 2017). Although you can take a deduction for home equity loans, this is only possible if the loan was used to build, buy, or substantially improve the home guaranteeing the loan. (Using the loan to pay off high-interest debt, like credit card debt, means you won’t qualify for this tax deduction).
These advantages, particularly a low rate for well-qualified borrowers, make a cash-out refi a great way to access the equity in your home.
Downsides of a Cash-Out Refinance
Unfortunately, there are also some potential downsides associated with a cash-out refinancing loan, including:
- You put your home at risk to guarantee the loan: Since your home is securing the loan, you risk foreclosure if you become unable to repay what you borrowed.
- You risk ending up underwater: The higher your mortgage balance relative to the value of your home, the greater the risk you could end up owing more than what your house is worth, also known as being underwater on your mortgage. If you can’t sell your home at a price high enough to pay off your loan amount, you’ll have to make up the shortfall yourself or get your lender to agree to a credit-destroying short sale.
- You may have to pay private mortgage insurance: If you owe more than 80% of what your home is worth, you have to pay private mortgage insurance (PMI). PMI protects your lender in the event you default on your loan. PMI typically costs around .5% to 1% of the amount you borrow in annual premiums. On a $200,000 mortgage loan, this could mean $2,000 per year in PMI costs.
Because of these downsides, taking a cash-out refinance loan is a good idea only if you’re 100% confident you can pay back what you borrow — and, ideally, if you’re not accessing the entirety of the equity you’ve built up in your home.
How Does a Cash-Out Refinance Work?
To obtain a cash-out refinance loan, you’ll need to be able to qualify for a new mortgage for the desired amount. The new mortgage needs to be big enough to pay off your old loan and give you the money you’re looking for to accomplish your other goals, such as making home improvements or paying for college.
You can apply for the new mortgage with your current lender or with a new lender. To qualify, you’ll generally need:
- A credit score of at least 620 to qualify for most mortgages, or at least 580 to qualify for a loan backed by a government program, such as an FHA loan.
- A home that appraises for at least as much as you want to borrow, and preferably 20% more than you hope to borrow.
- Proof of sufficient income to repay your new loan. Most lenders like to see that you’ve had a steady source of income for at least two years.
- A debt-to-income ratio of 43% or less, including your new mortgage payment. Debt-to-income ratio is calculated based on your monthly debt payments (including student loans) relative to your monthly gross income. If you’ll have total debt costs of $2,000 per month after taking out a new mortgage and you have a $4,000 monthly income, you probably won’t qualify.
- A home with no tax liens on it.
Many mortgage lenders have refinancing calculators on their websites so you can see the rates for which you’d likely be approved. You’ll need to shop around to find a lender with the best terms and then submit an application for the desired sum. After you apply:
- The lender will evaluate your credit, income, debts, and other financials.
- Your home will be appraised. The lender may also want an inspection to assess its condition and/or a survey to verify the land boundaries.
- The lender will let you know how much you can borrow and at what interest rate based on the value of your home and your financial situation.
- You’ll need to close on your mortgage loan, after which you will receive your loan proceeds. Your existing mortgage loan will be paid off from the proceeds before you’re given the remainder of the money.
There will likely be fees charged during this process, including an appraisal fee, a mortgage application fee, fees to obtain your credit report, and other miscellaneous closing costs depending on your lender and where you live.
Cash-Out Refinance Rates
The interest rate you’re assigned on a mortgage refinance loan will vary based on your Zip code, the amount you borrow relative to what your home is worth (your loan-to-value ratio), your credit score, and other factors.
Current mortgage rates for a 30-year fixed-rate loan are around 4.207% APR for qualified borrowers as of March 2019. For a 15-year fixed-rate loan, rates are around 3.661%. Rates are lower for jumbo loans, which are loans exceeding Fannie Mae and Freddie Mac loan limits for your geographic area.
Should I Choose a Home Equity Loan Instead?
A home equity loan also allows you to access the equity in your home, but these loans work differently. You don’t pay off your existing loan with a home equity loan; instead, you take out a second mortgage that’s secured by some of the equity in your home.
>> Read More: Cash-out refinance vs. home equity loan
Qualifying for a home equity loan can be harder than qualifying for a cash-out refi. There are certain other downsides, too, like the fact you may not be able to deduct the interest you pay.
Ultimately, a cash-out refinance can be a helpful financial tool, but you need to understand the risks before you take out a new mortgage to tap into your home’s equity.
If you’re confident you can pay back the loan and that the benefits outweigh the disadvantages, it’s time to shop around and find the most affordable loan for your situation.