A cash-out refinance replaces your current home loan with a new mortgage that’s higher than your outstanding loan balance. It allows you to take advantage of equity you’ve built up in your home by withdrawing the difference between the two mortgages in cash. Then, you can put the money toward home remodeling, consolidating high-interest debt or other financial goals.
When you refinance a mortgage, you simply replace the existing loan with a new one for the same amount, usually at a lower interest rate or for a shorter loan term, or both.
Cash-out refinancing, however, is different, because you’re withdrawing a portion of your home equity in a lump sum. You’ll pay more in interest after completing a cash-out refinance because you’re increasing the loan amount.
Lenders generally limit the amount you can withdraw to no more than 80 percent of your home’s value to ensure you maintain an equity cushion.
Say you still owe $100,000 on your home and it’s now worth $300,000. Let’s assume that refinancing your current mortgage means you can get a lower interest rate, and you’ll use the cash to renovate your kitchen and bathrooms.
Lenders generally require you to maintain at least 20 percent equity in your home after a cash-out refinance, so you’d be able to withdraw up to $140,000 in cash.
There are many advantages to using a cash-out refinance over other types of loan products if you need a large sum of money. Here are some common reasons to use a cash-out refinance:
Cash-out refinancing isn’t always the best move for every situation. Here are some reasons to avoid a cash-out refinance:
While lenders typically allow homeowners to borrow up to 80 percent of the home’s value, the threshold can vary depending on your credit score and type of mortgage.
Lenders who offer loans insured by the Federal Housing Administration, or FHA, sometimes offer a cash-out refi option for FHA loans that allow you to borrow as much as 85 percent of the value of the home. In addition, cash-out refi loans guaranteed by the U.S. Department of Veterans Affairs are available for up to 100 percent of the home’s value.
Expect to pay about 3 percent to 5 percent of the new loan amount for closing costs to do a cash-out refinance. Your closing costs can include lender origination fees and an appraisal fee to assess the home’s current value. Shop around with multiple lenders to ensure you’re getting the most competitive rates and terms.
You might be able to roll the loan costs into your new mortgage to avoid upfront closing costs, but you’ll likely pay a higher interest rate. Plus, taking out another 30-year loan or refinancing at a higher interest rate might mean you pay more in total interest. Crunch the numbers to make sure the math works in your favor.
A cash-out refinance might be eligible for mortgage interest tax deductions, so long as you’re using the money to improve your property. Eligible projects include things like:
In general, the improvements should add value to your home or make it more accessible in order to qualify.
There are other options you should consider before you start comparing rates on a cash-out refi, including:
A home equity line of credit or HELOC allows you to borrow money when you need to with a revolving line of credit, similar to a credit card. This can be useful if you need the money over a few years for a renovation project spread out over time. A HELOC interest rate is variable and changes with the prime rate.
A home equity loan is a second mortgage that gives you a lump sum amount and the interest rate is fixed, which helps homeowners budget for another monthly payment.
A personal loan is a shorter-term loan that provides funds for virtually any purpose. Personal loan interest rates can vary widely and can depend on your credit, but the money borrowed is typically repaid with a monthly payment, like a mortgage.
A reverse mortgage allows homeowners age 62 and up to withdraw cash from their homes, and the balance does not have to be repaid as long as the borrower lives in and maintains the home and pays their property taxes and homeowners insurance.
Do the math carefully to ensure that a cash-out refinance is the right avenue for your financial needs. Remember that you’re putting your house on the line as collateral, which means you could lose it if you fail to repay the new mortgage. Tapping your home equity isn’t a decision to make lightly, but doing so can offer you a strategic way to improve your overall financial picture if done with care.