Cash-out refinancing is one way to turn your home equity into cash, but not everyone qualifies

These mortgage loans turn your home equity—or the part of the home you actually own—into cash. You can then use those funds to cover home repairs, pay off debt, or put toward any expense you might deem necessary. 

Cash-out refinances tend to be most popular when the housing market is hot—and home values are rising. This allows homeowners to access more equity and, therefore, more cash. 

What is a cash-out refinance?  

A cash-out refinance replaces your existing mortgage loan with a new one—only with a larger balance. You then get the difference between two balances in the form of cash.  

This type of loan allows you to take advantage of the equity you’ve built in your home without selling it. Like a traditional refinance, you may be able to get a lower interest rate, but funds from a cash-out refinance can be used for any purpose. It’s an attractive option for homeowners in need of funds and who want to benefit from the equity they’ve built in their property.  

Some homeowners use them for home improvements or renovations. Others use them to pay off debt. 

“With the average mortgage refinance rate just a fraction of the average credit card interest rate, cashing out to pay down credit card or other higher-interest-rate debts may be a smart financial move,” says Al Murad, executive vice president at AmeriSave Mortgage Corp.  

Since a cash-out refinance replaces your existing mortgage, repayment functions the same. You’ll make monthly payments to your lender—usually for 15, 20, or 30 years, depending on your term—until the full balance is repaid.  

It’s important to note that cash-out refinances aren’t the same as home-equity loans. While both let you turn your equity into cash, a home-equity loan is a second mortgage—meaning a loan in addition to your main mortgage. This means you’ll have two monthly payments going forward. 

How does a cash-out refinance work?  

The process of applying for a cash-out refinance is very similar to getting a traditional mortgage. You fill out an application (it doesn’t have to be with your current lender), submit the required financial documents, get your home appraised, pay closing costs, and then close on your new loan. 

The new loan is used to pay off the old one, and you receive a payment for the remaining amount. 

Here’s an example: Let’s say your home is worth $500,000, and you have a current mortgage balance of $250,000. In this scenario, you might apply for a $325,000 cash-out refinance. After closing, the new loan would pay off your old one ($250,000), and you’d receive $75,000 to use however you’d like. 

What do you need for a cash-out refinance?  

Cash-out refinances often come with more stringent requirements to qualify than traditional mortgages. 

“Lenders consider cash-out refinance loan options to be of relatively higher risk,” says Jeremy Drobeck, a mortgage loan originator at AmeriFirst Home Mortgage. “The new loan amount leaves you with a larger balance than the original mortgage amount and with less equity.” 

While the exact requirements vary by loan program and lender, this is what you can generally expect when applying for a cash-out refinance: 

• Credit score: Your credit score will impact your ability to qualify and the interest rate you’ll receive. You likely need at least a 640 score or higher, though some lenders may go as low as 580. The higher your credit score, the better interest rate you can get.   
• Debt-to-income ratio (DTI): Your DTI indicates how much of your income is taken up by debt. Generally, you will need a 43% DTI or lower, which means your minimum monthly debt payments can equal no more than 43% of your take-home pay. In some cases, up to a 50% DTI might be allowed.  
• Loan-to-value ratio (LTV): The LTV reflects how much of your home’s value your loans comprise. Lenders typically want an 80% LTV or lower, which means you need to retain at least 20% equity in your home after your refinance. 
• Other requirements: You will also need proof of employment and a home appraisal, which confirms the current value of your property. 

Keep in mind that these are only general requirements. It’s always best to check with the lender to get specifics. 

Pros of a cash-out refinance  

Depending on your situation, there can be many advantages to cash-out refinancing. Among them:

• You can use the funds for any purpose. You might use them to pay for credit card bills, medical expenses, college tuition, or home remodeling projects. 
• You might get a lower interest rate. If current mortgage rates are lower than the rate on your existing mortgage, refinancing might enable you to save on interest payments long term. 
• The interest is tax-deductible. You can write off the interest you pay on up to $750,000 of mortgage debt. Keep in mind that you can take this deduction only if you itemize your tax returns (most people take the standard deduction each year). 
• You may be able to add value to your home. If you use the funds to remodel your home, you could increase your home’s value—and your eventual profits—should you choose to sell the house or tap into your equity again later. 
• They can help you pay off debt. Because mortgage loans usually have lower interest rates than other forms of consumer debt (credit cards, personal loans, etc.), using a cash-out refinance to pay off other balances could save you money in the long run. 

For existing homeowners, a cash-out refinance can also be a good alternative to selling and buying a new home—particularly in a high-cost market. 

“Because of the state of the market—prices have gone up so much—some people are doing a cash-out refinance and then using the money to remodel, to stay in their home,” Drobeck says. “Right now, a lot of people are saying, ‘Forget selling the house and paying $20,000 in realtor commissions. Let’s do a cash-out refinance, get $50,000, and redo the kitchen or put an addition on the house.’” 

Cons of a cash-out refinance  

Though cash-out refinances certainly have perks, there are downsides to these loans, too. Among them:

• It replaces your current mortgage loan’s rate and terms. Sometimes, this might work in your favor and reduce your interest rate and monthly payment. Or it may mean trading your current low rate for a higher one. 
• There are closing costs. You can expect to pay around 3% to 5% of the loan amount in closing costs. If you don’t plan to stay in the home long, these costs may not be worth it. 
• You may have a higher monthly payment. Since a cash-out refinance increases your balance—and potentially your interest rate—you may have a higher monthly mortgage payment as a result. 
• It may take longer to pay off your loan. If you refinance into a longer-term loan, it extends your payoff timeline (for example, refinancing to a new 30-year loan when you only have 10 years left on your current one). 
• You risk owing more on your home than it’s worth. If your home were to lose value, you might owe more than it’s worth. When that happens, you might not be able to sell the home and pay off your mortgage balance. 

Ultimately, it’s important to remember that refinancing means replacing your existing mortgage loan entirely—and that will mean a new rate, payment, and terms, too.  

“This typically makes sense when current mortgage rates are lower than those of your existing loan terms,” says Jon Giles, head of consumer direct lending at TD Bank. “However, if rates are higher, other variables need to be considered and analyzed to determine whether this is a smart financial decision in the long run.”

The takeaway 

Cash-out refinancing may be a smart move for some homeowners, but it’s not right for everyone.  

If you’re not sure whether a cash-out refinance can help you achieve your goals, talk to a loan officer or mortgage broker. They can help you determine if cash-out refinancing—or maybe an alternative product like a home-equity loan or HELOC (home-equity line of credit)—is best. 

“Everyone’s situation is different,” Drobeck says. “Talk to a loan officer and hash out the details.”