Cash-Out Refinance: How It Works and What to Know

With a cash-out refinance, you get a new home loan for more than you currently owe on your house. The difference between that new mortgage amount and the balance on your previous mortgage goes to you at closing in cash, which you can spend on home improvements, debt consolidation or other financial needs. 

However, you'll now be repaying a larger loan with different terms, so it's important to weigh the pros and cons before committing to a cash-out refi.

Whenever you refinance, you're starting over with a new mortgage that has different terms. You can use refinancing to change your interest rate or mortgage term, or to add or remove a borrower. None of this requires you to change the amount borrowed.

In contrast, a cash-out refinance gives you a new loan that's larger than your current mortgage balance. The difference between your new loan amount and what's owed is where you get the "cash out." 

How much cash depends upon your home equity — how much your home is worth compared to how much you owe.

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.

» MORE: See how much you could borrow with our cash-out refinance calculator

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:

• Debt-to-income ratio, or DTI. Your 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.

• Credit score. 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.

• Home equity. 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.

• Seasoning requirement. 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.

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 the collateral, you risk losing your home if you can’t make the payments. 

Before you sign, think through these pros and cons.

Pros:

• Potentially lower interest rate. 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.)

• Just one loan. Since it's a refinance, you'll be dealing with one loan payment per month. Other ways of leveraging home equity require a second mortgage.

• Access to more funds. 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.

• Helpful for debt consolidation. Using the money from a cash-out refinance to pay off high-interest credit cards could save you thousands of dollars in interest.

• May build credit. 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:

• Foreclosure risk. Because your home is the collateral for any kind of mortgage, 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.

• New terms. 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, possibly piling on a substantial amount of interest — even if you've lowered your rate.

• Time-consuming. 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 bet.

• Closing costs. 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.

» MORE: When's the right time to 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.

There are ways to tap into your home equity without doing a cash-out refinance. Home equity loans and home equity lines of credit, or HELOCs, also allow you to borrow against your home equity. They're both types of junior liens, or second mortgages, which means you take them out in addition to your current mortgage.

• Home equity loan: With a home equity loan, you borrow a lump sum — not too different from what you'd get with a cash-out refinance. However, since you aren't touching your primary mortgage, your interest rate won't change. With a home equity loan, you can borrow around 80% to 85% of your home’s value, minus what you still owe.

• Home equity line of credit: A HELOC is more flexible, giving you a line of credit that you borrow against as needed. Most HELOC lenders let you borrow up to 85% of your home’s value (minus what you still owe), though some lenders set higher or lower limits.

Both home equity loans and HELOCs have minimal closing costs, but because they are second mortgages, their rates are generally higher than you'd get with a cash-out refinance.