What is a cash-out refinance?

With a cash-out refinance, you borrow more money than what you owe on the home. Cash-out refis are useful if you're in a financial bind, but they're also risky.

Pat Howard 1600

Pat Howard

Published April 2, 2019

When you refinance your mortgage, you’re replacing your existing loan with a new loan to lower your interest rate or adjust your repayment terms. One such way to do this is through cash-out refinancing, which is when you refinance by borrowing more than what you owe on the home.

With a cash-out refi, you take out a larger loan which allows you to access your home’s equity and convert a portion of it to cash. The cash can then be used for everything from home repairs to educational expenses to consolidating your debt under a single monthly payment.

But the cash-out refinance option can be a risky one. When you refinance, you’re paying all of the same closing costs that you paid when you first took out a mortgage, and those fees could negate a good chunk of the cash you receive. Cash-out refinancing also means you have less equity in the home, which could make it harder to sell your home for a profit down the road.

In this article:

How does a cash-out refinance work?

A cash-out refi replaces your existing mortgage with a new loan that’s more than the amount you owe on the house. The difference between your new mortgage balance and the total loan amount then goes to you in cash and you can spend the money any way you like.

The amount of cash you’re eligible to borrow depends on two things:

Your home’s equity

Equity the difference between the appraised value of your home and your remaining mortgage balance. If your home is valued at $300,000 and your mortgage balance is $120,000, then you have $180,000 in equity.

Your mortgage’s loan-to-value ratio

The loan-to-value ratio (LTV) is the balance of the current loan divided by the appraised value, expressed as a percentage. In most cases, you can’t get a cash-out refinance if your LTV is higher than 80%.The home in the above example has an LTV of 40% ($120,000 divided by $300,000).

Cash-out refinance example

Most banks allow you to borrow up to 80% of your home’s equity in a cash-out refi, so if your equity was $180,000, you’d be eligible to borrow $144,000 in cash ($180,000 x 0.8) from your bank.

For the $300,000 home, if you chose to borrow the maximum lendable value, you’d then owe $264,000 on the refinanced mortgage under a new loan term.

How much does cash-out refinancing cost?

One of the downsides of cash-out refinancing is that it requires a number of the same closing costs that you paid when you initially took out the mortgage. (Cash-out refis without closing costs do exist, but they’re misleading because the costs are typically just rolled into the interest rate.)

Cash-out refinancing closing costs are typically anywhere from 3% to 6% of the mortgage. That means if the total loan amount is $200,000, you could be paying anywhere from $6,000 to $12,000 just in closing costs. If $50,000 of that loan was in cash, you’re potentially spending 20% of the cash you want on closing costs alone.

When to cash-out refinance

Cash-out refinancing may be worth looking into if you’re in a bind and need extra cash on hand for an important expense. Also, if your credit score has increased and your debt-to-income ratio is more favorable than when you first bought the home, you may be able to land a low enough interest rate to make a cash-out refi worth it.

But you shouldn’t focus solely on interest rates, either. Consider all the costs: your closing costs, your APR, your monthly payment, and the amount you’ll be paying over the life of the loan.

Here are some specific instances where cash-out refinancing makes sense.

For lower interest rates

Both regular refinancing and cash-out refinancing generally have lower interest rates than a credit card or a personal loan. You may even be able to find lower rates than those of a home equity loan or home equity line of credit (HELOC), which we’ll go over shortly.

If you bought the home when rates were high, a cash-out refi could have lower interest rates. Just be aware that the larger your loan, the more you’ll have to pay back over time, so only take out what you absolutely need.

For home repairs or improvements

One of the overarching reasons for a cash-out refinance is to spend the cash on a home improvement project or repair that will increase your home’s market value and add equity to your home. You may also be able to claim a tax deduction for interest you pay on the refi when you put it toward upgrades or repairs.

Check out our guide to home improvement loans.

Debt consolidation

Another popular use of the cash-out refis is to use the money to pay down all of your high-interest debt, like your student loan or credit card debt. While it’s enticing to not be saddled with high-interest debt, you’re creating potential problems that didn’t exist before.

Paying off credit cards or loans with home equity simply adds those debts to your mortgage, meaning the debt will follow you throughout the new 15- or 30-year mortgage term. If payments are too high down the road and start missing payments, you could lose your home.

If you’re considering using a cash-out refi for debt consolidation, crunch the numbers and make sure it’s actually saving you money in the long run. If it takes you 20 years to break even, it might make more sense to simply pay off your short term debt out of current cash flow.

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Why cash-out refinancing can be a bad idea

The biggest disadvantage of cash-out refis is that you’re increasing your mortgage amount while restarting the clock on your housing debt. Before you take out a cash-out refi, make sure the following apply to you:

  • You’re in a good financial position
  • You can keep ahead of your mortgage payments
  • You’ll be saving money down the line

Otherwise, you should avoid cash-out refis for the following reasons:

You’re extending your mortgage term

Extending your mortgage term with a cash-out refi may lower your monthly payment, but you’ll be adding both years and thousands of dollars to the life of your loan.

You’re not putting the money back into the home

You shouldn’t get a cash-out refi if you’re planning to use the loan to pay for things like a vacation or entertainment. But even using the funds to pay for an important expense like a car may not be the best idea.

Paying for a car with your mortgage could mean a lower interest rate than a car loan, but you’re also paying for a depreciating asset over a 30-year term rather than the initially scheduled six or seven year car loan. When you consider that you’ll dispose of the car long before your mortgage is paid off, financing your car with a cash-out refi isn’t a good idea.

Closing costs

As we went over earlier, you’ll pay the same closing costs from when you first bought the home. These costs can add up and may even chip into a good chunk of the refi cash. Some fees include:

You might have to pay private mortgage insurance

If a cash-out refi causes your equity in the home to dip below 20%, your lender will require that you get private mortgage insurance (PMI). You pay for PMI as part of your closing costs and you’ll keep paying for it as part of your monthly mortgage payment until you’ve paid off at least 20% of the mortgage balance.

Private mortgage insurance protects your lender if you stop making payments on the loan, and you’re typically only able to shed PMI once your loan-to-value ratio hits 78% according to your mortgage payment schedule.

In that sense, a cash-out refi could backfire if it results in you having to pay PMI, which is usually anywhere from 0.3% to 1.2% of the principal balance of your loan. That means if your mortgage balance is $150,000 and your PMI rate is 0.7%, you’ll pay around $1,050 in PMI for that year.

Cash-out refinance vs home equity loans

If you don’t have a need for refinancing but you still need extra cash on hand for an important home improvement project or repair, you should consider a second mortgage instead.

There are two main types of second mortgages: a home equity loan and a home equity line of credit (HELOC). Home equity loans and HELOC function similarly to a cash-out refi: your bank gives you access to up to 80% of your home equity, and that money can be put toward whatever you choose.

Like cash-out refis, second mortgages also use your home as collateral, so you risk foreclosure if you fail to make payments.

Home equity loans

A home equity loan is a lump sum loan that, like your original mortgage, you pay back over a 15- to 30-year term. Home equity loans can be beneficial for big, one time expenses that go toward the home. Interest rates on home equity loans are typically fixed, so you know exactly what you’re paying back over a set number of years.

The downside of home equity loans is if you overestimate your expenses and take out too much money, you still have to pay interest on the entire loan.

Home equity lines of credit (HELOC)

A HELOC functions like a credit card in that you only use the loan as you need it. You have your draw period, which is the 10-year period you use the funds, and the repayment period, which is the 20-year period where you repay the loan.

With a HELOC, you only pay interest on the amount you draw out. Lines of credit also give you flexibility, so if you have multiple home-improvement projects over an indeterminable amount of time, a HELOC might be the way to go. Another perk of HELOC is some banks don’t require closing costs, and lines of credit get processed rather quickly.

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