What is a Cash-Out Refinance?

UPDATED: May 5, 2022

For many Americans, their home is the biggest asset on their personal balance sheet. However, real estate is highly illiquid, meaning it's not quick and easy to convert it into cash. When homeowners begin looking for ways to access some of their equity, they typically across the option of a cash-out refinance. So what is a cash-out refinance? It's a popular method to "monetize" or receive cash for some of your ownership interest in your home.

Refinancing Basics

Traditional mortgage refinancing is when you pay off an existing mortgage with another one for the same amount. This is done for two common reasons:

1. To save money through a lower interest rate
2. To change the term of the mortgage.

For example, paying off a 30-year mortgage and taking out a 15-year term mortgage.

Refinancing to simply change the interest rate or loan term is called a “rate and term” refinance. The flexibility of a refinance allows homeowners to enjoy terms that fit their current financial situation. 

Traditional mortgage refinance comes in several forms. First, there’s the conventional refinance mortgage. These aren’t backed by any government mortgage programs such as FHA or VA. They tend to have the strictest credit requirements, but along with that they are the cheapest refinance loans available. 

Like their initial purchase counterparts, FHA and VA loans are backed by their respective government agencies. Interest rates tend to be higher with these, and the minimum equity requirement in the case of FHA loans is higher than a VA loan.

Cash-Out Refinance

Cash-out refinancing is a mortgage taken out with some of the cash going to the borrower. 

The extra cash is taken from your home’s equity, increasing the amount you owe on the house. Cash-out borrowers can choose whatever loan term they feel meets their needs and ability to qualify.

To compare multiple refinance offers with just your zip code, use this tool here:

How Much Money Can You Take Out?

You need a good bit of equity to be eligible for the cash-out option. Conventional mortgages have long required a 20% down payment for purchase loans if you want to avoid paying for private mortgage insurance (PMI). Because a refinance mortgage replaces your purchase mortgage (or sometimes an earlier refinance), the same minimum to avoid mortgage insurance applies. Therefore, in most cases you should keep 20% equity in your home. Most banks won’t let you take any cash out unless you have more than 20% equity. 

One reason for this condition is that the price of real estate fluctuates over time. Many of us remember the mortgage crisis of the mid to late-2000’s. Early on in the decade, unqualified buyers had been purchasing homes due to very loose mortgage standards. Prices rose, and those loans got bigger over time. Unfortunately, the market reached a tipping point and home prices cratered.

Many people found themselves “underwater” on mortgages due to having little equity. Foreclosures followed, after which many banks and mortgage companies went out of business. Disasters like this one could have been avoided with higher equity and credit requirements for borrowers.

Cash-Out Refinance Terms

The same basic options are available to homeowners who refinance their existing mortgages whether they take cash out or not. This means you can get a 30-year or 15-year fixed mortgage, an adjustable-rate mortgage, or a slew of other options. 

Some lenders will let you customize your loan terms. Whether you take cash out or not, custom term loans allow for term and rate flexibility. Customizing terms to your financial situation can save money and provide financial peace of mind.

If you’re taking cash out, the amount of the loan will increase. Shortening the loan terms will increase your mortgage payment, so you’ll want to be sure you the higher payment fits with your budget.

Costs

Most refinance mortgages have the same overall fee structure of their initial-purchase counterparts. That includes a home appraisal fee, credit application, inspections, closing costs, points, and more. Before taking cash out, you need to make sure that the loan is still affordable after the fees and other costs are taken into account.

While loan officers will walk you through this, it’s always wise to know your overall housing budget before sitting down with them. (If you don't have one, check out our guide about budgeting.) It’s prudent to verify you can take out enough money to accomplish the financial goals behind the cash-out transaction.

When Should I Consider a Cash Out Refinance?

Taking out a loan is an individual decision that should be made based on your unique circumstances. This applies to affordability questions, as well as your ability to be disciplined with the funds. Homeowners have done a cash-out refinance for any number of reasons. 

Major Repairs

A common reason that cash-out refinances are done is when the house needs significant repairs. For instance, it might need a new roof or siding. These repairs are expensive, and failing to do them can lead to bigger problems down the road. 

Remodel

Loan proceeds are often used to pay for upgrades to the home. These can actually increase the value, thereby replacing the lost equity through higher valuation. Remember, equity is the difference between your loan balance and the home’s value. Doing a cash-out refinance offers homeowners the opportunity to protect or upgrade their home while securing the outlay with their home’s value.

Debt Consolidation

If you have a lot of credit card or medical debt, one way to pay it off is by accessing the equity in your home. Credit cards have a very high interest rate, and medical debt has put many people into bankruptcy over the years. 

By consolidating the debt into your mortgage payment, you can save a lot of money on interest and possibly rescue your credit from the dumps. A word of caution, it can be tempting to pay off your credit cards only to run them up again. Doing this turns your house into an ATM and keeps you in a revolving debt cycle. If you’re able to improve your financial situation by rolling the debt into your mortgage, a cash-out refinance can make financial sense.

Going Back to School

People who want to go back to school can pay for it by doing a cash-out refinance. Student loan rates are generally higher than what you pay on a mortgage.  Borrowing against the value of their home is an inexpensive way to pay tuition. The potentially higher mortgage payment will start immediately, while student loan payments don’t start until you leave your program.

The cash out refinance is a viable option to receive cash for your ownership interest in your home. Proceeds can be used to pay off high interest rate debt, home remodel, or any other purpose.

Bottom Line

Cash-out refinances can be a great tool to tap equity in your home when done correctly. Its important to understand the benefits, as well as the risks, before proceeding. While it may seem like free money, its not. Working through your own budget and understanding the difference in cost is an important step in ensuring you don't go from What is a cash-out refinance? to This was a bad idea!

To quickly check local refinance offers with just your zip code, try this tool: