Cash-Out Refinance: How It Operates and When to Use It

With a cash-out refinance, you can convert your home equity into cash by taking out a new mortgage that is higher than your previous mortgage balance and receiving the difference in cash.

In the real estate world, refinancing in general is a popular process for replacing an existing mortgage with a new one that typically extends terms to the borrower that are more favorable. Refinancing a mortgage may allow you to lower the monthly payments, negotiate a lower interest rate, renegotiate the periodic loan terms, remove or add borrowers from the loan obligation, and, in the case of a cash-out refinance, access cash from the equity in your house.

How a Cash-Out Refinance Works

Your home can be used as collateral for a new loan and some cash if you decide to refinance, creating a new mortgage that is larger than your current one. You can easily get cash for emergencies, expenses, and wants by using the equity in your home.

A lender who is willing to work with borrowers looking for a cash-out refinance assesses the terms of their current mortgage, the amount the loan needs to be paid off, and the credit profile of the borrower before making an offer. The lender makes an offer based on an underwriting analysis. The borrower gets a new loan that pays off their previous one and locks them into a new monthly installment plan. There is a cash payment for the amount above and beyond the mortgage payoff.

In a standard refinance, the borrower would never receive any cash, just a reduction in their monthly payments. Typically, cash-out refinances are used to pay for large expenses like medical and educational fees, to consolidate debt, or for emergency funds, but the funds can be used as the borrower sees fit.

In a cash-out refinance, the lender takes on a greater level of risk, so closing costs, fees, or interest rates are higher than in a standard refinance. The U.S. Department of Veterans Affairs (VA) offers specialty mortgages, including cash-out loans, that can be refinanced at more favorable terms with lower fees and rates than non-VA loans.

1- The first step is to make sure you can afford the loan

Lenders check your income, assets, and credit to determine if you can afford your new monthly payment amount since you’re taking out a larger loan than you currently owe. You might come out with lower mortgage payments with a cash-out refinance if interest rates have dropped significantly since your first loan, but you’ll usually pay a higher monthly payment with a cash-out refinance.

2- Determine the value of your home

A home appraisal is often required and has been the standard way for many years to evaluate your home’s value. The appraiser compares your home to recently sold homes in your area with similar features and provides a value estimate. In 2023, you may have other options for determining the value of your home, including:

Acceptance of value:

Previously called an “appraisal waiver,” this option accepts the lender’s valuation of the home without an appraisal.

Property data plus value acceptance:

While this option eliminates the need for an appraisal and appraiser, it still relies on property data collected by a third-party professional.

A hybrid appraisal consists of:

In a hybrid appraisal, an appraiser and a property-data collector work together to value the property.

3- Determine how much you can borrow

It’s common for lenders to allow you to borrow up to 80% of your home’s value. This is also called a loan-to-value (LTV) maximum because it describes how much of your home’s value is being borrowed. With a VA cash-out refinance, eligible military borrowers may be able to take advantage of up to 90% of the value of their home.

4- Choose the best lender for your cash-out to refinance

LendingTree’s list of the best mortgage refinances companies includes several lenders that offer cash-out refinances. You can save thousands of dollars by comparing rates between three to five lenders.

Cash-out refinance requirements

Generally, you’ll need at least 20% equity to qualify for a cash-out refinance. You’ll also need to meet the program’s requirements for income, credit, and assets.

• A credit score of at least 620

A cash-out refinance requires a minimum credit score of 620, although some lenders may set a higher credit score requirement. A lower credit score may force you to stick with an FHA loan backed by the Federal Housing Administration (FHA), which has a more lenient credit requirement.

• The maximum debt-to-income ratio (DTI) is 43%

When you borrow more than you owe, your DTI ratio carries significant weight because it is a measure of your total monthly debt divided by your pretax income. A maximum debt-to-income ratio of 43% is recommended by the Consumer Financial Protection Bureau (CFPB), but lenders may make exceptions if you have a high credit score or extra savings.

• The occupancy rate

In most cases, borrowers take out cash loans against their primary residence. It is also possible to take out conventional loans against the equity in investment properties or second homes. However, you may have to pay a higher interest rate and be limited to a lower LTV ratio.

• Home type

If you’re borrowing against a condo or manufactured home, you may have to pay closing fees or interest rates that are higher.

• The waiting period

Unless you acquired the home through inheritance, divorce, or were otherwise awarded the house in a legal proceeding, a conventional loan requires six to 12 months before a cash-out refinance can be completed.

Cash-out refinance pros and cons

The chances of refinancing when interest rates are falling toward new lows usually appeal to savvy investors watching interest rates over time. While there are various types of refinancing options available to homeowners, most will come with additional costs and fees. Therefore, the timing of a mortgage loan refinancing is just as important as the decision to refinance itself.

If you need cash, consider your reasons for refinancing in addition to checking rates and fees. A refinancing option such as this usually offers lower interest rates than unsecured debt, such as credit cards or personal loans. If you are unable to pay your mortgage, for instance, or if your home’s value drops and you end up underwater on your mortgage, you could lose your home—unlike a credit card or personal loan.

In order to avoid losing your home if you are unable to make payments in the future, carefully consider if you need the cash for what you need it for. To avoid getting trapped in an endless cycle of debt reloading, take the steps necessary to get your spending under control if you need the cash to pay off consumer debt. To determine if a refinance is a good choice, the Consumer Financial Protection Bureau (CFPB) has a number of excellent guides.

The cash-out refinance typically provides borrowers with lower rates and other beneficial refinancing modifications, such as a payment break or forgiveness of some debt. In addition, the borrower may receive cash payments that can be used to pay down other high-interest loans, or alternatively, to fund a large purchase. This can be particularly beneficial in periods of low rates or during crisis situations, such as in 2020–21, following global lockdowns and health scares.

Cash-out refinance vs. HELOC

A home equity line of credit (HELOC) is a little bit like a credit card — you can borrow up to a certain amount as needed. The draw period, during which you can access the money, usually lasts 10 years, and you may only pay interest during this time. Generally, the line of credit is secured by your home equity and will be repaid once the draw period is over. Repayment periods can be quite long — around 20 years on average.

Home equity loan vs. cash-out refinance

Home equity loans are another way to tap into your home equity, which are simply loans secured by your home equity. You leave your existing mortgage as-is and take out a smaller loan secured by your home equity instead of taking out a large loan to pay off your current one. In most cases, the funds are received in a lump sum and repaid over a fixed period of time, typically between five and 30 years.

Second mortgages are also called home equity loans since they are second in line to be repaid after your current first mortgage if you lose your house.

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