Cash-out refinance: how it works and what to know

How much cash can you get from a cash-out refinance?

Lenders usually require you to maintain at least 20% equity in your home, though this can vary by lender and loan type. If your mortgage is backed by the Department of Veterans Affairs, for example, you may be able to borrow 100% of your equity with a VA cash-out refinance.

In general, you can borrow up to 80% of your home’s value, but it’s wise to borrow only as much as you need. If you still have a balance on your original mortgage, you’ll have to subtract that from the cash you could receive.

Here’s an example:

• Determine your home equity: Let’s say your home is worth $300,000. You have $100,000 remaining on your loan. Home equity is the market value of your home minus what you still owe. In this example, you have $200,000 in home equity.
• Calculate the maximum loan you can take out: In general, that’s 80% of your home’s value. In this example: $300,000 x 0.80 = $240,000.
• Subtract your current mortgage balance: From that new $240,000 loan, you’ll have to pay off what you still owe on your home: $240,000 – $100,000 = $140,000.
• Estimate your total: In a cash-out refinance, you receive the difference between the balance on your previous mortgage and your new, larger mortgage: in this example, it’s as much as $140,000.

Since the amount you can borrow with a cash-out refinance depends on your home equity, your lender will require an appraisal to assess your home’s current value. If home prices have risen in your area, your property may be worth more than the price you paid, increasing the amount you could borrow.

Cash-out refinance requirements

In order to get a cash-out refi, you’ll have to meet lender requirements. These can vary and, as always, it’s smart to shop around for the best interest rate.

But you’ll likely need to meet these qualifications:

• Your Debt-to-income ratio, or DTI, is your monthly debt payments – including your current mortgage – divided by your gross monthly income. For a cash-out refi, you’ll usually need a DTI of 40%-50% or less.
• As usual, a higher credit score should help you get a better interest rate, but you may qualify for a cash-out refinance with a score of 620.
• You’ll usually need at least 20% equity in your home to qualify for a cash-out refinance. In other words, you’ll need to have paid off at least 20% of the current appraised value of the house.
• With a conventional loan, you’ll need to have owned the house for at least six months to qualify for a cash-out refinance, regardless of how much equity you might have. Lenders might make an exception if you inherited the property, or it was otherwise legally awarded to you. For VA loans, you must wait 210 days from the first payment or after you make your sixth monthly payment (whichever is longer). If you have a loan backed by the Federal Housing Administration, you need to have lived in the home for at least 12 months before doing an FHA cash-out refinance.

Pros and cons of a cash-out refinance

A cash-out refinance can be a wise move or a risky one, depending on your financial situation and how you plan to spend the money.

In a cash-out refinance, you can access a large amount of cash at a relatively low interest rate (compared to personal loans or credit cards, for example). However, since you’re using your home as collateral, you risk losing your home if you can’t make the payments.

Before you sign, think through these pros and cons.

Pros:

• • Though cash-out refinance rates tend to be higher than rate and term refinance rates, you might still end up with a lower interest rate if mortgage rates were higher when you originally bought your home. However, if you only want to lock in a lower interest rate on your mortgage and don’t need the cash, a rate and term refinance makes more sense.
  • Since it’s a refinance, you’ll be dealing with one loan payment, on one loan, per month. Other ways of leveraging home equity require a second mortgage.
  • Cash-out refinances are helpful with major expenses, like a home renovation or college tuition, because you generally can borrow much more than you could with a personal loan or by using credit cards.
  • Using the money from a cash-out refinance to pay off high-interest credit cards could save you thousands of dollars in interest.
  • Paying off your credit cards in full with a cash-out refinance may build your credit score by reducing your credit utilization ratio – the amount of available credit you’re using.

Cons:

• • Your home is the collateral for any kind of mortgage, and you risk losing it if you can’t make the payments. For this reason, experts usually advise against using one to pay off unsecured debt, like credit card balances. Lenders don’t typically go after your home for unpaid card bills.
  • Your new mortgage will have different terms from your original loan, so review them carefully to understand what changed. Also, take a look at the total interest you’d pay over the life of the loan. Assuming you’re refinancing into a new 30-year mortgage, that could add years of repayment and possibly pile on a substantial amount of interest – even if you’ve lowered your rate.
  • You’re getting a new mortgage, and while you won’t jump through all the hoops of a purchase loan, underwriting can still take weeks. If you need funds urgently – say your leaky roof is causing serious water damage and needs replacing ASAP – refinancing may not be your best option.
  • You’ll pay closing costs for a cash-out refinance, as you would with any refinance. Refinance closing costs are typically 2% to 6% of the loan: That’s $4,800 to $14,400 for a $240,000 refi. This can take a big bite out of the cash you’ll receive at closing.

Tax implications for a cash-out refinance

Do you need to pay taxes on the money you receive from a cash-out refinance?

No. Since this cash is considered a loan, it’s not subject to income tax. However, depending on how you spend the cash, you might be able to write off the interest you pay.

Generally, you can deduct the interest (up to IRS limits) if you spend the money on permanent projects that add value to your home. Check with a tax professional, but those can include adding a bedroom, replacing your roof or installing a swimming pool. Routine repairs or painting typically don’t count, since they don’t increase your home’s value.

If you use the cash for reasons outside of home improvement, such as tuition payments or debt consolidation, you can’t deduct the interest.

Is a cash-out refinance a good idea?

A cash-out refinance can make sense if you can get a good interest rate on the new loan, and depending on what you plan to do with the money. Seeking a refinance to fund vacations or a new car isn’t a good idea because you’ll have little to no return on your money. On the other hand, using the money to fund a home renovation can rebuild the equity you’re taking out.

Either way, you’re using your home as collateral for a cash-out refinance, so it’s important to make payments on your new mortgage loan on time and in full.