Do you have grand home remodel aspirations, critical property repairs, or another steep expense looming? You’re probably wondering how to best finance the initiative.
Homeowners with substantial equity may consider a cash-out refinance. It can be a savvy way to extract cash from the value of your home. But it can be costly.
The answer as to whether it’s a good idea depends largely on the terms of your current mortgage—but there are other factors to consider, as well. Here’s what you need to know about a cash-out refinance.
What is a cash-out refinance?
A cash-out refinance is a way to access your home equity (the value of your home minus the amount you still owe on your mortgage). With this borrowing method, you’ll trade in your current mortgage for one that amounts to more than you currently owe—and keep the difference in cash.
That extra cash will be deposited similarly to any other loan. You’ll get a lump sum in your bank account that you can spend essentially any way you want.
How does a cash-out refinance work?
Let’s say you owe $50,000 on a $400,000 mortgage. This means you’ve got $350,000 in equity (possibly more if your home has increased in value since you purchased it).
Lenders typically allow you to take out a loan for up to 80% of your home’s value. In this example, you may be able to open a loan for up to $320,000. That’ll cover the $50,000 that you currently owe on your mortgage, plus an extra $270,000 in cash. You’ll effectively be starting your mortgage all over, but it could be a shrewd move if you need to borrow a substantial amount of money.
Costs and fees of a cash-out refinance
A cash-out refinance isn’t free—beyond the interest you’ll pay each month, you can likely expect between 3% and 6% in closing costs. This includes:
- Home appraisal
- Home inspection
- Title search fees
- Home owners insurance
- Escrow reserves
- Loan origination fees
- Notary and legal fees
Using the aforementioned $320,000 loan example, you may pay between $9,600 and $19,200 in closing costs alone.
When does a cash-out refinance make sense?
As you can see, a cash-out refinance isn’t always a good idea for those who need a large loan. Consider the following before you commit.
Are you making practical purchases?
First things first: Do you need the funds for sensible expenses or are you tempted to make discretionary purchases?
Using a cash-out refinance for things like home renovation can be an excellent idea, as a smart renovation can increase the value of your house and result in an increase in your net worth.
On the other hand, taking a luxury vacation, furnishing your home with the latest electronics, or buying a depreciating asset like a boat is not the smartest way to use your home equity.
Can you get improved mortgage terms?
A cash-out refinance is a new mortgage. You can tweak your repayment term, switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, remove a co-borrower, etc.
One of the biggest factors to consider is your mortgage rate. If you can get a notably lower interest rate than your current mortgage, it can go a long way toward lowering the overall cost of borrowing money in the form of a cash-out refinance.
Do you plan to borrow a lot of equity?
A cash-out refinance makes the most sense when you need a large chunk of your equity. As we’ll discuss shortly, those borrowing a small-to-moderate percentage of their equity may do better with a home equity loan—which doesn’t require an overhaul of your current loan.
For example, if your car needs a few thousand dollars of repairs, you may want to use a home equity loan, personal loan, etc. to pay for that purchase instead of restructuring your entire mortgage.
Pros and cons of a cash-out refinance
Pros
- Possibility to access to more funds than you can get from a standard personal loan
- Often comparatively low APR compared to other types of financing
- Potential opportunity to lower your mortgage rate
Cons
- Increase your overall mortgage payment
- Loan is secured by your home
- Closing costs may be expensive
How to qualify for a cash-out refinance
Qualifying for a cash-out refinance is similar (though not identical) to qualifying for a standard mortgage. You’ll need things like:
- A solid credit profile: You’ll generally need a credit score of at least 620 to qualify. Higher is better to give yourself decent odds at a low interest rate. Focus on low credit utilization and on-time payments with your current loans and lines of credit.
- A reasonable debt-to-income ratio (DTI): Your DTI is the percentage of your monthly income that is dedicated to paying current debts, such as credit card balances, installment loans, auto loans, etc. With a refinance, the bank will factor in your new mortgage payment (instead of your current one). Lenders tend to require a DTI of 45% or below to qualify.
- Stable (and sufficient) income: Lenders want to know that you’ve been employed with reliable pay for at least two years.
All these things weigh on whether you’ll be approved (and how much you can borrow if approved).
The big difference from a regular mortgage is that you’ll need sufficient equity in your home for a cash-out refinance. Again, financial institutions generally require that you keep at least 20% of your home’s value untouched. If you’ve only achieved 20% equity or less, this likely won’t be the way to go.
Cash-out refinance vs. HELOC vs. home equity loan
A cash-out refinance isn’t the only way to borrow from your home’s equity. Here are other popular options that may work better for your situation.
Home equity loan
A home equity loan is similar to a cash-out refinance in that you’ll receive a lump sum of cash upon account opening. But instead of replacing your current mortgage with new terms, a home equity loan is a “second mortgage.” In other words, you’ll maintain your current mortgage, but you’ll also have an additional monthly loan payment.
A home equity loan can be a better choice than a cash-out refinance if you’re happy with your current mortgage and you don’t plan to borrow an enormous amount of equity. It can also be cheaper, as cash-out refi closing costs tend to be less expensive. Plus, having a separate loan means you can repay that balance faster—instead of rolling it into an interest-incurring loan that may last 30 years.
Home equity line of credit (HELOC)
A HELOC is also a form of a second mortgage, but the way you receive your funds is fundamentally different from a cash-out refinance. Instead of receiving an upfront sum, you’ll be given access to a revolving line of credit. You can spend as little or as much as you choose (though some enforce a minimum draw upon account opening). You’ll only pay interest on the amount you spend. And, similar to a credit card, you can re-spend the balance as you repay it.
HELOCs are composed of two phases: a “draw” period and a “repayment” period. During the draw period, you can fund purchases with your loan. This phase usually lasts several years. The repayment period follows, obligating you to repay any outstanding balance either in monthly installments or all at once.
A HELOC is probably your best option if you plan to make regular large purchases and pay them off. It can also be a good emergency fund, as you won’t get dinged for interest if you don’t use the money.
Alternatives to a cash-out refinance
Of course, dipping into your home equity isn’t the only way to fund a large expense. Here are some other common methods that aren’t subject to closing costs and minimum equity percentages:
- Credit card: Your credit card should typically not be the first choice when it comes to financing an expense that will take months (or years) to pay off. Credit cards tend to come with much higher interest rates than other loans. However, some offer new customers an introductory 0% APR window on purchases upon account opening that lasts a year or longer. If you can pay off your credit card balance before interest kicks in, it could be your best option.
- Personal loan: A personal loan is an unsecured loan that works similarly to a home equity loan. You’ll get a lump sum deposited into your bank account, and you’ll be set up on an installment plan of equal monthly payments until your principal and interest have been repaid. Personal loans are often capped at $100,000—unlike borrowing from your equity, which can be much higher depending on how much you’ve built.
- Borrow from friends and family: Perhaps the least ideal is asking your loved ones for a loan. It can save you from paying interest and all the formalities that come with opening a bank loan, but it does come with the risk of strained relationships. Be sure to communicate and establish clear expectations with each other if you go this route.
The takeaway
A cash-out refinance allows you to pocket a portion of your home equity by replacing your current mortgage with a new loan larger than what you currently owe. You’ll receive a new interest rate, and you’ll have the opportunity to change details about your mortgage (repayment terms, loan type, etc.).
If you’ve got a large upcoming expense for which you can’t pay in cash—and if mortgage rates are notably lower than when you first opened your mortgage—this could be a great tactic to get the funding you need. Just do the math to ensure that the associated closing costs, which can often run in the 3% to 6% range, are justifiable.
Frequently asked questions
What is a cash-out refinance on a mortgage vs. a regular refinance?
A regular mortgage refinance is simply taking your current balance and restructuring it, from altering the repayment period to changing the loan type. It’s subject to the current mortgage rates, as well. A cash-out refinance is similar, except you’re taking out more than your current balance—thereby dipping into your equity. You can then use the excess money for almost anything.
How much cash can I get with a cash-out refinance based on my home equity?
You can typically get up to 80% of your home equity from a cash-out refinance. However, the actual amount you can borrow will depend on factors like your credit score and debt-to-income ratio.
What credit score do you need to qualify for a cash-out refinance?
Many lenders require a credit score of at least 620 to qualify for a cash-out refinance.
Is a cash-out refinance a good idea for consolidating high-interest debt?
A cash-out refinance can be a good idea for consolidating high-interest debt, as it generally comes with a comparatively low interest rate. But it also comes with closing costs. A home equity loan may be a better tool to eliminating high-interest debt, as its closing costs are lower and it remains a separate loan that can often be paid off sooner than rolling that bill into a lengthy mortgage.
How long does a cash-out refinance take to close and fund?
A cash-out refinance often takes between 30 and 45 days to close and fund.
