How Does a Cash-Out Refinance Work?

Where can you turn if you own a home but need extra money? Instead of using credit cards or taking out a personal loan, consider a cash-out refinance. With this option, you replace your mortgage with a new one and tap into your equity in the form of cash taken at closing. 

The major benefits of a cash-out refinance are a lower interest rate and a lower monthly payment. But, cash-out refinancing has drawbacks. You must pay closing costs. Your lender will reset your loan’s term. A home equity loan or HELOC may be a better alternative. 

Before choosing, learn what is a cash-out refinance and how a cash-out refinance works, Investigate the pros and cons of a cash-out refi.

What is cash-out refinancing?

Chances are that, like many homeowners over the past few years, your residence has increased in worth due to rising property values. This helps homeowners build equity, which is the difference between what you owe on your mortgage loan and the property’s current market value. There are different ways to withdraw equity from your home without selling it. One of the most popular options is a cash-out refinance.

With a cash-out refinance, you replace your existing primary mortgage loan with a new larger mortgage loan. The difference between the two loans, minus any closing costs, gets distributed to you as cash out at closing. Essentially, you are extracting equity you’ve built up and liquidating it as cash. But that cash is being borrowed from the lender, which is why your new mortgage loan balance owed will be larger than the one it replaced.

While you can opt for a cash-out refi with an adjustable rate, most choose a fixed interest rate. Ideally, the new interest rate will be lower than what you pay on your current mortgage loan.

Cash-out refinancing loan purpose

Homeowners pursue cash-out refinancing for several good reasons.

“Cash-out refinancing is an excellent way to consolidate debt, pay for home improvements, fund business expenses, or pay for a child’s education. It’s also used to finance a wedding, purchase an investment property or second home, pay for medical bills, or hold for emergency expenses or other needs,” says Matt Hackett, operations manager for Equity Now in Mamaroneck, New York.

You can use the funds from a cash-out refi for virtually any legal purpose. But due to the paperwork and closing costs involved, this financing option is probably best utilized when you have a significant expense far exceeding what you would charge on a credit card or borrow from a friend or loved one.

“A good candidate for a cash-out refinance is anyone who has a loan-to-value ratio under 70% and who can use the additional funds to make a measurable difference in their lives or finances,” says Eric Jeanette, president of Dream Home Financing.

Cash-out refinance pros and cons

Table: Summary of Pros and Cons

On the plus side, a cash-out refi allows you to access a large sum of money, which you will receive relatively quickly upon closing the loan. Suppose you’ve accrued significant equity in your home and qualify. In that case, you can take out potentially tens of thousands of dollars in the form of cash out.

Additionally, you will likely pay a lower interest rate for a cash-out refinance than other forms of financing. That’s because you are using your home as collateral for the loan, which provides extra peace of mind to the lender, resulting in a relatively affordable rate of interest.

Furthermore, because you are resetting your loan, you have the option to change the repayment period. You can shorten the term to, for example, 15 years or prolong the repayment over 20 to 30 years. Lengthening your term will likely result in lower monthly mortgage payments. Decreasing your term will increase your monthly payments but allow you to pay off the loan in a shorter time, reducing the total amount of interest paid.

Also, you may be eligible for a mortgage interest tax deduction if the money you cash out is used to make significant improvements to your home (consult a tax expert for details).

On the negative side, your home is used to secure the loan. In other words, you could face foreclosure and lose your home if you cannot make your payments on time or in full.

In addition, you may pay a higher interest rate on this new mortgage loan than what you currently are charged. Remember that mortgage rates have gone up in recent months. Note also that lenders typically charge a higher interest rate on a cash-out refi than a refinance that doesn’t involve taking cash out. A higher interest rate will equate to paying thousands more over the life of the loan.

What’s more, closing costs can be expensive on a cash-out refinance. Often, they equate to 2% to 5% of the amount borrowed, which can add up quickly. Plus, the process involved can be more complex and time-consuming than other forms of financing. You will need to supply financial documentation and probably need to pay for a new appraisal done on your home to qualify. And it can take up to 60 days to close.

Cash-out refinancing requirements

To qualify for a cash-out refi, expect to:

• Have a sufficient credit score. Many lenders require at least a 580 credit score; others desire a 620 or higher score.
• Have a favorable debt-to-income ratio. Aim for a DTI of 43% or less, although some financial institutions permit a DTI of 50% or less.
• Demonstrate sufficient equity. Many lenders require you to keep at least 20% equity in your home following a cash-out refinance. If you qualify for a VA loan cash-out refi, you may be allowed to withdraw 100% of your equity.
• Furnish financial proof. Prepare to provide key documents the lender may request, including paystubs, proof of employment, W-2s, financial statements, and more.
• Pay for a new appraisal to determine the value of your home.
• Wait if you just took out a mortgage loan. This is called “loan seasoning.” It often requires waiting at least 12 months from when a new loan was created.

How do you get cash with a cash-out refinance?

The equity you liquidate in the form of cash out will be paid to you in a lump sum after closing. You commonly must wait a few days to receive these funds, which will be deposited in your designated bank account or given to you in the form of a check.

The reason for the delay is that your lender is obligated to provide a three-day window following closing to allow you to cancel the refinance if you change your mind.

Alternatives to a cash-out refinance

Rest assured that a cash-out refi isn’t your only choice here. Instead, if you qualify, you could select a:

• Home equity loan (a second mortgage) that enables you to borrow against up to 85% of the value of your home, minus any outstanding mortgage debt. This loan also uses your home as collateral.
• Home equity line of credit (HELOC) that is a type of revolving credit with a variable interest rate. You use your home as collateral to obtain a revolving line of credit from a lender. A HELOC has a draw period in which you can utilize the available credit line as you wish and make interest payments. This is followed by a repayment period in which you pay off the loan with principal and interest.
• Personal loan, that doesn’t use your home to secure the loan but often charges higher interest rates.
• Credit cards, which offer instant funds but assess the highest interest rates.
• Sell your home. “If you live in a high-cost area and your kids are out of the house, you may want to take the equity out by selling your home and moving to a lower-cost area,” suggests Hackett.