What Is a Cash-Out Refinance, and How Does It Work?

A cash-out refinance replaces your current mortgage with a new, larger loan, paying you in cash the difference between the amount borrowed and what you owe on the home.
Jan 6, 2022

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With a cash-out refinance, you're getting 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.

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How does a cash-out refinance work?

Whenever you refinance, you're starting over with a new mortgage that has different terms. Refinancing can be used to get a new interest rate, change the length of the mortgage or to add or remove a borrower. Any of those goals can be accomplished without changing the amount borrowed.

In contrast, with a cash-out refinance, you're getting a new loan that's for more than you owe on your current mortgage. 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.

Say your home is valued at $200,000 and your mortgage balance is $100,000, giving you $100,000 of equity in your home. You could refinance your $100,000 loan balance for $150,000 and receive $50,000 in cash at closing.

Because how much 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.

Lenders will usually require you to maintain at least 20% equity in your home, though this can vary by lender and by the type of loan. 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.

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 to see which lender will offer you 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 no higher than 45%.

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 as low as 620.

Home equity. You'll usually need to have 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 for a cash-out refinance regardless of how much equity you might have. Exceptions are made only if you inherited the property or it was otherwise legally awarded to you. VA loans also require a six-month wait. If you have a loan backed by the Federal Housing Administration, you'll have to wait at least 12 months before doing an FHA cash-out refinance.

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Pros of a cash-out refinance

Potentially lower interest rate. Though cash-out refinance rates tend to be higher than rates for purchase loans, you might still end up with a lower interest rate if mortgage rates were higher when you originally bought your home. For example, in 2018, the average rate on a 30-year fixed mortgage went as high as 4.94%. These days, rates are considerably lower. (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.

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.

Higher credit score. 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 of a cash-out refinance

Foreclosure risk. Because your home is the collateral for any kind of mortgage, you risk losing it if you can’t make the payments. If you do a cash-out refinance to pay off credit card debt or finance college tuition, you'll be paying off unsecured debt with secured debt — a move that's generally discouraged because of the possibility of losing your home.

New terms. Your new mortgage will have different terms from your original loan. Double-check your interest rate and fees before you agree to the new terms. 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 5% of the loan — that’s $4,000 to $10,000 for a $200,000 refi. This can take a big bite out of the cash you'll receive at closing.

Private mortgage insurance. If you borrow more than 80% of your home's value, you'll have to pay for private mortgage insurance. For example, if your home is valued at $200,000 and you refinance for more than $160,000, you’ll probably have to pay PMI. Private mortgage insurance typically costs from 0.55% to 2.25% of your loan amount each year. PMI of 1% on a $180,000 mortgage would cost $1,800 per year.

Save thousands on your loan by comparing cash-out refi offers

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Alternatives to cash-out refinance

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.

With a home equity loan, you borrow a lump sum — not too different from what you'd get with a cash-out refinance, though since you aren't touching your primary mortgage your interest rate won't change. A HELOC is more flexible, giving you a line of credit that you borrow against as needed. 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.

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.

Frequently asked questions

With a cash-out refinance, you take out a new mortgage that's for more than you owe on your existing home loan, but less than your home's current value. You'll receive the difference between the new amount borrowed and the loan balance at closing.

Shop around with multiple lenders to compare cash-out refinance rates. You may also be able to buy points to bring down your refinance interest rate. While you're comparing lenders, be sure to also check the costs and fees associated with getting the refinance. These don't affect your rate, but fewer added fees will lower your closing costs.

You can't do a cash-out refinance on a conventional loan or a VA loan until you've met a six-month seasoning requirement. With an FHA loan, you aren't eligible for a cash-out refinance for 12 months. With all of these, there are possible exceptions for circumstances like divorce or inheritance.

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