Cash-out refinance: How does it work?

If you’re looking for ways to tap into your home’s equity, a cash-out refinance loan might be one option to consider. It allows you to convert some of your home’s value into cash, while replacing your existing mortgage with new terms.

In this article, we’ll cover:

• What is a cash-out refinance loan and how does it work?
• What are the requirements for a cash-out refinance loan?
• What are some pros and cons of a cash-out refinance loan?
• Are there any alternatives to a cash-out refinance loan?

What is a cash-out refinance loan and how does it work?

A cash-out refinance is a home mortgage that replaces your existing mortgage with a new, larger loan, and you take the difference between the old mortgage and the new as cash. You’ll receive the cash at closing, and you can use the funds for any purpose debt consolidation, home renovations, or education costs, for example. You’ll still make one monthly payment.

The new mortgage is secured by your home, which means you’ll need sufficient home equity and a qualifying credit profile to quality. A home appraisal and title search is usually required. You’ll begin repaying the new, larger loan immediately, at a new interest rate.

What are the requirements for a cash-out refinance loan?

To qualify for a cash-out refinance loan, you’ll need to consider several factors. They include:

• Credit score: Higher credit scores are viewed more favorably by lenders and may help you get a better interest rate. Generally, the benchmark for a cash-out refinance loan is a credit score of 620.^{Disclosure 1,Disclosure 2}
• Home equity: You’ll need sufficient equity in your home to qualify. A common requirement is having a minimum of 20% equity remaining in your home after the cash is taken out. This is also expressed as an 80% loan-to-value ratio. Use our calculator to determine how much equity you have in your home.
• Debt-to-income (DTI) ratio: This ratio compares your total monthly debt payments (including mortgage, credit cards, and auto loans) to your gross monthly income. Most lenders prefer a DTI of less than 50%.
• Employment and income history: You’ll need a stable income and employment history.
• Seasoning: You’ll need to be in your home for a specific period, such as 6 months to a year, before you can qualify for a cash-out refinance. In addition, your home must be your primary residence, and your current mortgage must be in good standing.
• Home appraisal: A home appraisal is usually required to determine the current market value of your home.

These are general guidelines and may vary according to different lenders and because of your personal circumstances. Our mortgage payment calculator can help you estimate how much your monthly payments might be.

What are some pros and cons of a cash-out refinance loan

While a cash-out refinance can provide funds for major expenses, there are some risks and downsides involved that you may want to consider.

Pros:

• A cash-out refinance lets you tap into a significant portion of your home equity, likely more than you could with a personal loan or credit card.
• Interest rates on cash-out refinance loans are usually lower than on unsecured debts such as credit cards. If interest rates have dropped from your initial mortgage, you may get a lower interest rate on the cash-out refinance.
• You can use the money to consolidate your high-interest debt into one single payment with lower interest.
• The interest you pay on the refinance mortgage may be tax-deductible if funds are used for home improvements.^{Disclosure 3} The cash you receive isn’t considered taxable income.
• Unlike a Home Equity Line of Credit (HELOC) which may have a variable rate, you can secure a fixed interest rate, meaning predictable payments and budgeting.

Cons:

• Extending your mortgage term and increasing your loan amount may mean you pay more in interest over the life of the loan.^{Disclosure 1}
• Taking out a larger loan will increase your debt burden. Regular payments will ensure you keep possession of your home.
• Borrowing against your home’s equity will reduce how much equity you have to borrow from in the future.
• Just like a standard mortgage, a cash-out refinance loan comes with closing costs, which may be an upfront expense.^{Disclosure 1}
• A cash-out refinance resets your loan term and restarts the clock, meaning it can take longer for you to own your home outright.
• If your home appraisal is lower than expected, you may not get the amount of cash you wanted. 

Are there any alternatives to a cash-out refinance loan? 

There are some other options to a cash-out refinance loan you can consider. These include:

• Home equity loan: A home equity loan is a mortgage that provides a fixed lump sum with a fixed interest rate. Unlike a cash-out refinance, it doesn’t replace your primary mortgage, so you would have two separate loan payments.
• Home Equity Line of Credit (HELOC): A HELOC is a revolving line of credit that functions similarly to a credit card—you borrow funds as you need them up to a set limit. HELOCs typically have variable interest rates, but may have lower closing costs compared to a cash-out refinance.
• Personal loan: A personal loan is an unsecured loan that doesn’t use your home as collateral. It may carry a higher interest rate than a mortgage, but may be a faster option with fewer fees.

A cash-out refinance can be a great way to unlock your home’s potential while getting cash to pay expenses or start an emergency fund. Thoroughly examining your needs and your personal and financial situation can help you decide whether it’s the best option for you.