How Cash-Out Refinancing Works: When Is It The Right Option?

By Alvaro Moreira
10 min read

What Is Cash-Out Refinancing? 

Cash-out refinancing is a mortgage option that enables homeowners to convert their home equity to cash. This means you can access whatever equity you have built up over time and use the money to finance almost anything from consolidating high-interest loans and home remodelling to any other financial emergency. 

cash-out refinancing

How Does It Work? 

Cash-out refinance is almost the same as rate-and-term mortgage refinancing, which allows you to swap the old loan with a new one (of the same amount) but for a shorter loan term, lower interest, or both. The only difference is that you can withdraw a portion of the lump sum to finance other projects, which is almost impossible with rate-and-term mortgages. 

According to Alvaro Moreira (the Chief Loan Officer at Moreira Team), cash-out refinancing is beneficial in that you can take advantage of your home equity and even use funds from the same for other projects. If your current mortgage balance is at $100,000, for example, and your home is worth $300,000, you might be able to access around $200,000 in home equity. Refinancing the current mortgage this means a lower interest rate, and on top of that, use part of the cash to renovate your home (think kitchen and bathroom renovations). 

For this to work, you’ll be required to maintain at least 20% home equity after cash-out refinance. In this case, you’d be able to borrow up to a maximum of $140,000 cash and still have $60,000 home equity. You’d be required to pay appraisal fees and other closing costs – usually deducted from the borrowed amount.

One notable thing about cash-out refinancing is that you will have paid more in interest compared to the initial mortgage rate. This is, of course, because you’d have increased the loan amount, which automatically translates to higher interest and closing costs. Applying for cash-out refinancing is almost the same as your first mortgage application. You only need to apply with your preferred lender, avail the required documents, wait for the application to be approved, and then wait for the closing of the same. 

Preparing For Cash-Out Refinancing: Tips and Ideas

Here are a few tips and steps to preparing for cash-out refinancing: 

1. Familiarize Yourself with The Lender’s Minimum Requirements

Every lender has a different set of requirements that one has to meet to qualify for cash-out refinancing. Your credit score is the first qualifying factor, a reason you want to ensure yours isn’t tainted. Most lenders will also look into the debt-to-income ratio, where you’d have to be above a certain percentage. A 20% home equity is another universal requirement among most lenders. It would thus be advisable to look into every potential lender you can find and compare the conditions and rates. 

2. Calculate How Much You Need

Cash-out refinancing is an excellent option when/if in need of funds for a particular purpose. Regardless of how much you qualify for, it would help if you had a good idea of how much you’ll need for that specific course. If you are looking to renovate your home, getting estimates for materials and labor from different contractors can help you compute the right amount to borrow. If you plan to consolidate all your debts, gather all credit card and personal loan statements, and then figure out how much you owe. You might also want to consult a financial expert for help determining how much to borrow. 

3. Gather All the Documents and Information Needed to Apply

By shopping around for different lenders, you’ll have a good idea of what will be required of you. You can also contact your preferred lender to inquire about the same. Prepare all the documents and financial information needed for the application; this includes current debt, assets, and income. Some lenders may ask for additional information to process and approve your application. 

Essential Things to Note Before Applying for Cash-Out Refinancing

1. You can’t withdraw all your equity:  Many lenders require one to uphold at least 20% of their home equity in cash-out refinancing. Only VA cash-out refinance makes it possible for individuals to withdraw up to 100% of their home equity. 

2. The terms of your loan could change:  The terms of cash-out refinancing might differ greatly from the original mortgage loan. The repayment period, for example, may be longer or shorter, while your interest rates could go higher or lower. Many variables will change with the new loan in place. 

3. Your home will have to be appraised: Any lender will require a fresh home appraisal before processing your loan application. This is the only way they can be sure of your home’s equity. 

4. You’ll cover closing costs: You will be required to pay for, among other costs, appraisal and lenders fees. Unless you are looking to borrow a significant amount, the closing costs in cash-out refinancing aren’t worth it. You could save a lot by using a different financing option. 

5. The cash isn’t available immediately: Unlike most loan options where you can access the money after approval, you’d have to wait for up to three days after closing to access the funds. The 3-day wait period is meant to give you enough time to decide whether you need this financing option or not. You can thus choose to cancel the application within this period. 

How Much Can I Borrow from A Cash-Out Refinance?

The much you can borrow through cash-out refinance varies from one lender to the other, though most lenders only allow up to 80% of the value of your home. This, again, depends on the type of property attached (e.g., four-unit, duplex, single-family property etc.), mortgage type and your credit score rating. Loans insured by the FHA (Federal Housing Administration) can sometimes offer FHA cash-out loans of up to 85% home value. You can access up to 100% cash-out refinancing under the VA program. The U.S. Department of Veterans Affairs guarantees such loans, hence applicable for those that qualify. 

Cash-Out Refinance Fees: How Much Should I Expect to Pay

Closing costs for cash-our refinance range between 3 and 5% of the loan amount. The closing costs may include appraisal and lender origination fees, among others. These fees will vary between lenders, a reason you should shop around for several lenders before settling for one. Some lenders may be more expensive than others, another reason you want to compare rates first. 

Although you could roll the fees into the new mortgage (hence avoid closing costs), there’s a good chance the interest rates will be higher than the original one. This means you’ll pay more interest, especially if the loan is to be repaid in a long time, say 30 years. The smart move here would be to crunch the number first (use Bankrate’s refinance Calculator) to see which option favors you best. 

Advantages And Disadvantages of Cash-Out Refinance

Like everything else, cash-out refinancing has its good and bad sides. When it comes to finances, the wise option is to consider both the good and the bad before going through with the application. Outlined below are some of the advantages and disadvantages of cash-out refinance you should know about. 

Advantages Of Cash-Out Refinance

1. A lower interest rate

Cash-out refinance makes it possible for one to get a bigger loan but at a slightly lower interest rate than standard loans. This is one of the main reasons many homeowners use this option. 

2. A lower borrowing cost

Typically, mortgage refinances rates are much lower than other loans, including credit cards and personal loans. The total cost of borrowing (including closing costs) is considerably lower, especially when looking to borrow large amounts of money. It is also the most accessible and affordable form of financing for many homeowners. 

3. Can help boost your credit score

Cash-out refinancing can be an excellent way to improve your overall credit rating when used to pay off a debt. You can thus use cash-out refinance to avoid missing large or high-interest loans, which could impact your credit rating. 

4. Eligible For Tax Deductions

Using the funds for home improvement also means you could enjoy more tax deductions. You’d however have to check with the IRS eligibility requirements to ensure you do qualify for such deductions. 

Disadvantages Of Cash-Out Refinance 

1. Your interest rate could go up

While most people use this option to bring their interest rates down, there are instances when cash-out refinancing will attract a higher interest. It thus wouldn’t be a good financial move in this case. 

2. You might need private mortgage insurance (PMI)

Although it might be nice to access up to 90% of the value of your home, you might be required to pay for PMI if you do so. Private mortgage insurance is required until you can get back to the recommended 80% equity threshold. Although it might not seem like much, this is still money out of your pocket. 

3. It could prolong your debt repayment

Using cash-out refinance to consolidate debt could translate to paying for debts for several more years or decades. Crunch the numbers first to see how long it would take to repay the loan and if it would take longer than the original one. While loan consolidation might seem like a great option, it doesn’t make financial sense to spread a credit card debt over 20 years or more when you could have paid it off in a few months or years. According to McBride, cash-out refinancing is more beneficial when used for home improvements and not for debt consolidation. 

4. A higher risk of losing your home

Whatever the reason is for wanting cash-out refinance, you risk losing the home should you fail to repay the loan on time. This is one of the reasons most financial advisors will recommend seeking other financing options rather than putting your home on the line. If need be, consider applying for just the amount you need, and use it for that specific purpose alone to avoid making the situation worse. 

5. You Might Squander the Money

The chances of using the cash for non-essentials, such as paying for a vacation, are too high, especially for anyone struggling with debt. Unless you can keep your spending habits in check, cash-out refinancing might not be a wise option. 

Cash-Out Refinancing and Taxes

You might be eligible for tax deductions (on mortgage interest) if you use the funds for home improvement. Some of the qualified home improvement projects include

– Putting up a new fence around your home

– Adding a new bedroom or bathroom

– Adding a hot tub and/or swimming pool in the backyard

– Putting up a new roof

– Replacing windows

– Upgrading your central heating or air conditioning unit

– Installing a new home security system.

In most instances, projects that add value to your home could be eligible for tax deductions. You only need to confirm those you are eligible to first. 

Is Cash-Out Refinancing A Good Idea? 

This depends on what you intend to use the cash for. Most people, however, find this option a worthy decision and would go for it any time. 

Mortgage interest rates are considerably much lower than other types of loans. This is because most lenders consider mortgages low-risk, so they choose to keep interest rates low. That said, cash-out refinancing might be the most affordable and cheapest way to access large amounts of money. You can thus use the funds for: 

1. Home improvement projects: 

It makes perfect sense to use the funds for home improvement projects. This will help boost the value of your property while keeping costs down (considering tax deductions).

2. Investments: 

You can use the money to invest in another property or build a retirement home. 

3. Consolidate high-interest debts: 

 Cash-out refinancing attracts a lower interest rate compared to many types of loans. Credit cards, for example, have a higher interest – you can use the cash-out refinancing option to repay or consolidate these loans. 

4. Pay for a child’s education:  

It makes more sense to use cash-out refinancing to pay for your son/daughter’s education than anything else. Interest rates on the same are much lower and more manageable. 

Home Equity Loans Vs Cash-Out Refinancing 

A home equity loan can be loosely defined as a second mortgage while a cash-out refinance involves taking a larger loan to repay the mortgage and then using the difference. Although you might know this already, a second mortgage will always attract a higher interest rate than what you’d pay for a cash-out refinance.  

Alternatives Of Cash-Out Refinancing

1. HELOC

HELOC (Home Equity Line of Credit) is almost similar to credit cards as it allows you to borrow money based on your line of credit. If looking to take on a home renovation project to pay back within a few years, this would be a viable option. HELOC, however, attracts prime interest rates. 

2. Personal Loan

This is one of the most common and preferred funding options. However, personal loans have a shorter repayment period, sometimes just a month or two. Interest rates also vary depending on one’s credit rating and borrowed amount. 

3. Reverse Mortgage

This option allows seniors (62 and above) to withdraw cash from their homes for as long as they live. The borrower doesn’t have to repay the borrowed amount but must pay homeowners insurance and property taxes for the same. The lender acquires the property upon the death of the borrower.