Cash-Out Refinance: What It Is And How It Works

If you have expenses piling up or a home project you need extra cash to finance, you may wonder where you can pull extra money from.

Why not look into a cash-out refinance? You can pull money out of the equity in your home to use for anything you wish – yes, even that much-needed basement renovation you've been thinking about ever since you moved in.

Here's what you need to know about a cash-out refinance and why it might be a good option for your situation:

Get To Know A Cash-Out Refinance

Mortgage refinancing means tapping into the valuable home equity you've built up in your home. When we say "equity," we mean the amount you've paid off on your home after subtracting your mortgage balance and additional liens.

What is a cash-out refinance, exactly? Cash-out refinancing is a type of refinance that allows you to borrow money against your home's equity. You receive a new mortgage that's larger than your current mortgage balance. Your lender pays off the original mortgage, and you receive the difference in cash between the two loans.

Lenders typically allow you to withdraw about 80% cash to spend in a cash-out refinance. For example, if you had $100,000 of equity in your home, you could withdraw around $80,000 and use it for whatever purpose. Note that you may need at least 20% of equity in your home to qualify for a cash-out refinance, but that depends on your lender's rules and requirements.

Learn more about cash-out refinancing.

Cash-Out Refinance Example

How does a cash-out mortgage refinance work? Let's look at how it might work using an example. Let's say you purchased a home for $300,000 and would like to take $30,000 to build a brand-new deck. In simple terms, it would look like this:

• Home purchase price: $300,000
• Amount of home paid off: $70,000
• Amount owed on the mortgage: $230,000 (you can figure this by subtracting $300,000 from $70,000)
• Cash amount needed: $30,000

In this example, you add the amount of equity you want to borrow to what you currently owe on your mortgage:

$230,000 + $30,000 = $260,000

The $260,000 is your new mortgage amount, leaving $30,000 to spend on the new deck.

How Much Money Should You Expect To Receive?

The amount of money you'll receive depends on your home's equity. As mentioned, you can usually borrow no more than 80% of your home's value, including in an FHA cash-out refinance.

However, VA cash-out refinances pose an exception to this 80% rule – you can take up to the full amount of your existing equity. Rocket Mortgage^® allows you to do so as long as you have a credit score of at least 620.

A cash-out refinance calculator can help determine how much you can borrow and your new monthly mortgage payment after refinancing. You'll supply information like your:

• Refinance goal
• Current mortgage balance
• Current home value
• Desired amount you want to borrow
• Whether you are a veteran or served in the military
• ZIP code
• Credit score

Consider using the refinance calculator from Rocket Mortgage to help you learn about your options and get an estimate.

Cash-Out Refinance Requirements

Qualifying for a cash-out refinance requires you to apply. Your application must reveal that you meet your lender's refinancing requirements, including:

• Credit score: Your lender will want to know your credit score, a three-digit number that details how you handle debt and how well you've taken care of your creditors in the past. They want to assess how much of a risk you pose before you refinance. VA and FHA loans will require at least a 580 credit score for a cash-out refinance, while a conventional loan requires at least a 620 credit score.
• Debt-to-income (DTI) ratio: Lenders also want to check your debt-to-income ratio (DTI). Your DTI refers to your total monthly standing debts and payments (like credit cards or personal loans) divided by your total monthly income. Most lenders like to see borrowers with a DTI of 50% or less. For example, if you have $1,000 in monthly debts but bring in $5,000 in income, you have a DTI of 20%.
• Loan-to-value (LTV) ratio: Your LTV ratio measures the appraised value of a home you want to refinance against the loan amount you want to borrow. Lenders use it to show they aren't loaning too much. You can calculate LTV by dividing the total loan amount by the appraised value for the property and converting it to a percentage. For example, say you have a $225,000 loan on a home appraised at $300,000 – the LTV would be 75%.
• Home equity: Lenders will not want to lend to you without the right equity amount. You can gain equity when your home increases in value or by paying your monthly mortgage payments on time, every time.
• Closing costs: Like when you bought your home, you'll pay closing costs, including credit report, appraisal and attorney fees (attorney fees depend on your state).

5 Steps To A Cash-Out Refinance

We'll walk through some steps on how a cash out mortgage refinance works. Note that the process is similar to a regular refinance, where you replace your current mortgage with new terms and a new interest rate.

1. Determine How Much Cash You Need

Determining how much cash you need is an important first step during the cash-out refinance. If you have a project, put a budget and plan in front of you. Most cash-out refinances cap withdrawals at 80% of the equity you've built up in your home.

2. Ensure You Can Afford The New Loan

Can you afford a new loan and new loan terms?

Your interest rates may increase when you refinance your loan because you borrow more than you owe on your mortgage. This means that it will cost you more per month for each monthly payment. If you can get a lower interest rate than when you applied for your first mortgage, your monthly payment could decrease or stay the same.

3. Find Out How Much Your Home Is Worth

Determine how much your home is worth through a home appraisal. A home appraisal occurs when an appraiser, an independent third party, evaluates your home to determine its value. An appraisal will determine the amount a lender will lend to you – they don't want to lend more than the home is worth. An appraiser looks at your property and also evaluates other comparable properties in the area to give your property a fair assessment.

4. Compare Cash-Out Refinance Rates

Don't just look at one lender for a cash-out refinance. Compare lenders and review interest rates for a cash-out refinance among several lenders so you can ensure you're getting the best deal. Look beyond the money and evaluate the lender's reputation, customer service and other factors that make it a good lender to work with.

Pros And Cons Of A Cash-Out Refinance

We'll outline the benefits and drawbacks of getting a cash-out refinance before deciding whether or not it will work for you.

Pros

The benefits include:

• Lower interest rate: You may tap into a lower interest rate with a cash-out refinance, which could save you money over your loan term. You may save thousands over many years.
• Improve your credit: Taking out a loan and making on-time payments will always help you improve your credit. Improving your credit score can allow you to borrow in the future.
• Potential tax deductions: You can take advantage of the mortgage interest tax deduction with a mortgage on your home. You can deduct up to $750,000 as a single filer or married couple filing jointly. The limit is $375,000 for those married but filing separately.
• Can put equity to use: You can put your home equity to use where it would otherwise stay tied up in your home, untapped.

Cons

The drawbacks include:

• Higher payments: Cash-out refinances require you to make higher payments per month because you will take out more for a refinance than what you took out in your original mortgage. These higher payments could cost you thousands more than your original mortgage over the life of your loan.
• Private mortgage insurance: If you don't have 20% equity in your home, you may have to pay private mortgage insurance (PMI). PMI is insurance that your lender requires you to pay to protect them – it doesn't benefit you as the borrower at all. PMI generally costs around 0.1% – 2% of your loan amount each year.
• New terms: New terms might mean that your monthly payment is higher. This means it could take you longer to pay off your mortgage loan.
• Pay closing costs: You'll pay closing costs with a refinance just as you did with your original mortgage loan, meaning you will have to earmark some cash to pay closing costs. You'll pay between 2% – 6% of the principal of your mortgage in closing costs.
• Your home serves as collateral: Your home is the collateral for the loan just like your original mortgage. If you default on your mortgage, your lender could repossess your home.

When To Consider A Cash-Out Refinance

So, when should you consider a cash-out refinance? When is it right for your situation? Check out some common examples and situations where a cash-out refinance is beneficial:

• Home improvement and renovation projects: A cash-out refinance is a great option if you've built some equity in your home and need to free up your money for home improvements and renovation projects.
• Investment opportunities: A cash-out refinance may help you make worthwhile investments. For example, remodeling your kitchen may increase the value of your home. You may also take out money to invest in your retirement.
• Debt consolidation: You can refinance to pay off debt. For example, if you owe money on student loans or other debt, you can use a cash-out refinance to pay off those debts and transfer the money to a place where the debt will accrue interest at a lower rate – on your mortgage. Credit card interest rate, for example, can be much higher, sometimes above 20%, and a mortgage interest rate will be much lower.
• Secure a lower interest rate: You may be able to secure a lower interest rate with a refinance compared to your original mortgage interest rate. Compare your old rate with the refinance rate.

Alternatives To Getting A Cash-Out Refinance

If a cash-out refinance doesn't seem like the right option for you, know that there are additional options and ways to use your home equity besides cash-out refinancing. Here are a few alternatives:

• Home equity loan: A home equity loan is a type of second mortgage that, like a cash-out refinance, allows you to borrow against the equity in your home. However, you don't receive cash in exchange for a higher loan amount like you do with a cash-out refi.
• Home equity line of credit (HELOC): A HELOC is another type of loan where you can borrow against your home equity. Instead of getting a lump sum, you draw from the loan during a draw period, where you pay minimum or interest-only monthly payments. During the repayment period, you repay the balance, typically over 10 – 20 years.

Cash-Out Refinance FAQs

Do you still have questions about cash-out refinances? Here are some frequently asked questions about cash-out refinances that you may be wondering:

What can I use my cash-out refinance for?

You can use your cash-out refinance for any purpose, from a vacation you've always dreamed of to consolidating debt to renovating your home. Consider the current interest rate for your current mortgage if you plan to refinance and ensure a refinance benefits you.

How soon can I get a cash-out refinance?

You'll need to have owned a property for at least 6 months before you can get a cash-out refinance. In addition, remember that you must also have the right amount of equity in your home to qualify.

Are there taxes on a cash-out refinance?

You may wonder whether you must pay taxes on the money you receive through a cash-out refinance. However, the answer is no. Since it is a loan from your lender, the IRS doesn't consider the cash you receive as taxable income.

How much are closing costs on a cash-out refinance?

You'll have to save some money to cover the closing costs on a cash-out refinance. You'll pay between 2% – 6% of the principal of your mortgage in closing costs.

What factors influence my interest rate on a cash-out refinance?

Several factors influence your interest rate on a cash-out refinance, including your credit score, DTI, LTV and amount of home equity.

The Bottom Line

Cash-out refinancing allows you to borrow more than you owe on the existing mortgage and get the difference in cash. It can allow you to use your hard-earned equity you've built up in your home for whatever you need it for, which gives you much flexibility.

Ready to pursue a cash-out refinance? Get started today and explore your options.