What is a cash-out refinance?
Updated April 5, 2022
A cash-out refinance allows homeowners to refinance their mortgages by replacing their old loans for larger ones. The difference between the two loans is then given to the homeowners as cash at closing, which they might use to pay for home renovations or other pressing financial needs. This also means that homeowners who use a cash-out refinance now have a larger mortgage to pay off, and with different terms.
Typically, when homeowners refinance their mortgages, they do so to secure different terms on their loan: lower interest rates, for example, or a shorter term for the loan. In a cash-out refinance, homeowners can tap into the equity in their home by taking out a new, larger loan to access a substantial amount of unrestricted funds. For example, if a homeowner took out a $500,000 mortgage and has paid off $250,000, the latter is the amount of equity they have in their home. They could refinance their loan for $350,000, and take the $100,000 difference in cash at closing.
However, the terms of the new loan may include higher interest rates.
What are the steps to getting a cash-out refinance?
Lenders have particular requirements for cash-out refinances. In order to determine whether a borrower qualifies for this type of loan, banks will look at the amount of equity they have in their home, the home’s loan-to-value ratio, and the borrower’s credit score and debt-to-income ratio. Borrowers may also be asked to share financial documents, like bank statements and pay stubs.
A cash-out refinance allows homeowners to replace their own loans for bigger ones and use the cash for other expenses. Credit: Scott Graham/Unspl
The borrower’s home will be appraised again, and if its value has increased, they may be able to refinance for a higher amount. There are limits, though: most banks allow borrowers to take out no more than 80% of the home’s value, unless their mortgage is a VA loan, in which case they can withdraw the full amount of their equity. Homeowners should consider in advance, though, how much cash they actually need before a cash-out refinance. The process of underwriting the loan may last a few weeks, but once the refinance is approved, closing should take only a few days.
Cash-out refinance vs. home equity loan
Another way to use one’s home equity to get a lump sum of cash is to take out a home equity loan. This involves borrowing against one’s home equity by taking out an additional mortgage, rather than replacing the original mortgage, as one does with a cash-out refinance.
A home equity line of credit, or HELOC, is a line of credit that lets homeowners borrow against their equity, withdrawing and repaying funds as they would with a credit card. HELOCs may come with draw periods, a period of time in which borrowers are allowed to withdraw and repay funds. Unlike a cash-out refinance, which offers borrowers a one-time lump sum of cash, HELOCs allow homeowners to borrow money on a continuous basis.
Home equity loans, HELOCs, and cash-out refinances all come with fees and require borrowers to make repayments on a timely basis.
Who should consider this type of refinance?
For borrowers who need a lump sum of cash for a specific expense, a cash-out refinance can often be a more cost-effective way of getting a loan, as the interest rates for repayment will typically be lower than that of credit card payments or other types of loans. At the same time, these borrowers should be confident that they will be able to pay off a larger mortgage on time.
Advantages of a cash-out refinance
- It’s an affordable way to get a lump sum of cash to fund expenses like home upgrades, college tuition payments, debt consolidation, and investments
- Borrowers can lock in a favorable interest rate if they keep an eye on the market
- If borrowers keep up with repayments on a cash-out refinance, they can improve their credit score
Disadvantages of a cash-out refinance
- Borrowers will face increased mortgage payments, and those who can’t keep up with them face the risk of foreclosure
- Cash-out loans often come with higher interest rates than typical refinances
- Borrowers must pay closing costs on the new loan
- Depending on how much they take out, borrowers may also have to pay for private mortgage insurance on the new loan