What is a cash-out refinance?

As you build equity in your home, you may want to turn that illiquid asset into cash. There are several options for doing so, like taking out a second mortgage, home equity line of credit, or securing a cash-out refinance.

A cash-out refinance loan replaces your existing mortgage with a new one for more than you currently owe on your home. Your lender then pays the difference between your old mortgage and your new one — in cash — for you to spend on home improvements or other expenses.

But this cash comes at a price: Your new loan will be for a higher principal with different rates and terms than your previous one. This can mean higher interest rates and greater monthly payments.

A cash-out refinance might be right for you if you’re looking to capitalize on your home equity. But don’t act without first understanding the cost of this refinancing option.

How does a cash-out refinance loan work?

Unlike a rate-and-term change refinance — which only changes the rate and terms of your home loan — a cash-out refinance puts money in your pocket. 

Like any refinance, a cash-out refinance swaps your old mortgage for a new one. The unique feature of a cash-out refinance is that your loan amount is for more than you currently owe on your existing mortgage. The difference between what you owe and your new mortgage total is where your cash comes from.

For example, let’s say that your home is valued at $400,000.

• Your mortgage balance is $150,000, which means that you have $250,000 of built up equity in your property.
• You refinance your $150,000 mortgage balance for a new total of $225,000.
• You’ll get $75,000 cash at closing ($225,000-$150,000), not factoring in closing costs.

Your home will serve as the collateral for both the cash and your new mortgage. Your lender will order a home appraisal to evaluate your property and help calculate the total tappable equity.

How home equity impacts your cash-out refinance loan

For a sense of how home equity factors into a cash-out refinance, let’s look at an example of a homeowner who purchased a single-family existing-home 10 years ago at the then median sales price of $169,000. According to the National Association of Realtors, their home is likely to be worth $363,100 today, which means they have built up $225,000 in home equity through the combined effects of appreciation and paying down their mortgage.

Let’s say our example homeowners have a mortgage balance of $137,700. They could refinance their mortgage balance for $200,000 and get $62,3000 in cash ($200,000-$137,000) while maintaining $163,100 of equity ($363,100-$200,000) in their home.

These homeowners benefit from the 10 years of payments they’ve made as well as the staggering effects of home appreciation. They’re like many American homeowners who, on average, have $207,000 of tappable equity in their home.

Requirements of a cash-out refinance

Not all homeowners are eligible for a cash-out refinance. To qualify, you’ll need to meet the lender’s requirements, which can vary. Typically, though, homeowners will need to meet the following criteria:

• Home equity: You’ll need to have accumulated at least 20% equity in your house to qualify for a cash-out refinance. To return to our example homeowners who purchased a single-family existing-home 10 years ago at the then median sales price of $169,000. For simplicity, we’ll base our calculations on appreciation alone, and not factor in the payments they made towards their mortgage. These homeowners would need to have waited until their property was valued at $202,800 before pursuing a cash-out refinance.
• Debt to income ratio (DTI): Your debt to income ratio is the percentage of your gross monthly income you put towards paying off your debts. Most lenders require a DTI of 45% or less.
• Credit score: A higher credit score will help you secure better interest rates, but most people can qualify for a cash-out refinance with a credit score of 620 or greater.
• Seasoning requirement: As with any refinancing option, you might have to wait before you can apply for a cash-out. Wait times will vary depending on the type of mortgage you have and your lender, but for most conventional loans, you can expect to wait at least six months.

How much cash can you get?

The amount of money you receive from your cash-out refinance will depend on the equity you have built up in your home. Your home equity will depend on:

1. How much of your mortgage that you’ve paid off
2. How much your home has appreciated in value

If you’ve paid off a significant portion of your mortgage, your home has appreciated a lot of value, or both, you’ll be able to take out more money.

Most lenders will require you to maintain 20% in equity in your home in order to maintain a loan-to-value ratio of 80%. However, this can vary depending on your loan, lender, and credit score. For example, some VA cash-out refinances permit homeowners to borrow up to 100% of their home’s appraised value.

Tax implications of a cash-out refinance

Another reason to consider a cash-out refinance is because of its tax-friendly benefits. The money you receive from a cash-out refinance is tax-free, because the IRS considers this money to be an additional loan, not true income. 

More good news: You can deduct the interest on your original loan balance to lower your overall tax burden. Depending on how you plan to spend your cash-out, you may qualify for additional tax deductions.

Capital home improvements

If you use your cash-out to make capital improvements on your home, you can deduct the interest you pay on the portion of your loan that you refinance if you make a capital improvement.

A capital improvement is anything that adds value or longevity to your home or adapts it for a different use. Think of these as big-ticket changes to your home, not minor tweaks or fixes like painting walls or fixing an HVAC system. 

Examples of capital home improvements include:

• Replacing windows with more energy-efficient models
• Upgrading your roof
• Putting in a pool
• Adding a home office

Rental property improvements

The IRS considers the income you make from charging rent on a rental property you own as personal income. So if you used a cash-out refinance to improve, repair, or close on a rental property under your management, you could deduct those expenses from your federal tax return.

Discount points

You may have the option to purchase discount points as a part of closing on your cash-out refinance loan. These points are fees that you pay upfront to lower your interest rates in the long run.

They’re also 100% tax-deductible. However, the deductions don’t come all at once. Rather than a one-time deduction in the year you closed on your loan, discount point deductions are typically spread out over the lifespan of your loan.

Learn about qualifying for the mortgage interest deduction

Is a cash-out refinance right for me?

This refinancing can be a good option for homeowners who have built up equity in their home and need liquid cash, whether to renovate their home or invest in other areas of their lives. But a cash-out refinance comes with some considerations.

Pros

• Turn equity into cash: Perhaps the biggest advantage of a cash-out refinance loan is the ability to quickly turn your home’s value into money in your pocket. This can help house-rich but cash-poor homeowners who are looking to use that money for whatever they need.
• One loan: Unlike a second mortgage, which allows homeowners to access their home equity with a second home loan, a cash-out refinance keeps things simple with just one loan.
• Consolidate debt: Homeowners with a lot of high-interest debt — like that from credit cards — can use their cash out to pay off or pay down these debts and save thousands of dollars on interest.
• Potentially lower interest rates: Interest rates for cash-out loans tend to be roughly 0.125% to 0.25% higher than other types of refinancing. However, when interest rates drop to historic lows (like they did in 2020 and 2021), you may be able to secure a lower interest rate than other types of loans.

Cons

• Closing costs: As with any refinance, a cash-out comes with closing costs. They typically run 2% to 5% of the loan, which can add up fast. Factor this total into your calculations on whether a cash-out refinance is right for you.
• Private mortgage insurance (PMI): Private mortgage insurance protects your lender in the event that you don’t complete your payments, and if you borrow more than 80% of your home’s value, you may have to purchase a PMI policy.  
• Foreclosure risk: Your home serves as the collateral for your cash-out refinance loan. If you can’t make the payments, you risk foreclosure on your home. Consider this risk, especially if you use the money from your refinance to pay off credit card debt or fund discretionary expenses. Financial advisors generally discourage trading secured debt (like your home) for unsecured debt (like credit cards) because of the risk of foreclosure.
• New terms: You may have gotten used to the terms of your previous mortgage, but when you refinance, you’ll start over with all new ones. Work with your mortgage officer to ensure that you understand your new terms in the short and long run before agreeing to them.