What Is a Cash-Out Refinance? (2024)

Vault’s Viewpoint on Cash-Out Refinances

• The amount you can borrow for a cash-out refinance is usually capped at 80% of your home value.
• Factors like your home equity, the type of mortgage you have and your lender’s criteria affect the limit.
• Applying for the cash-out refinance is a matter of submitting a mortgage application and going through an underwriting process.
• A cash-out refinance may be a good option if you need a large amount of cash and can afford the payments, but consider alternatives if rates have climbed since you took out your first home loan.

What Is a Cash-Out Refinance?

A cash-out refinance loan allows you to replace your mortgage with a new loan that has different terms. You borrow more than you currently owe and keep the difference as cash, which you can use for any purpose. Then you repay the new, larger loan over time according to the new terms.

For instance, let’s say you owe $200,000 on your home and you have $160,000 in tappable equity. If you borrow the maximum amount, your new loan will be equal to your original loan balance of $200,000 plus the new cash balance of $160,000, for a total of $360,000. Your monthly loan payment would increase accordingly.

How Much Can You Borrow With a Cash-Out Refinance?

The amount you can borrow with a cash-out refinance is usually capped at 80% of your home value. But the limit can vary depending on the type of mortgage you’re getting and the lender’s requirements.

With a conventional loan, you can borrow between 70% and 80% of the home’s value, depending on the property type and number of units. Mortgages backed by the Federal Housing Administration (FHA loans) come with an 80% loan-to-value (LTV) ratio limit on cash-out refinances, while mortgages insured by the Department of Veterans Affairs (VA loans) may let you tap all of your home’s equity. On top of these limits, lenders will consider your financial standing when setting your loan amount.

To calculate your potential borrowing power, start by subtracting your mortgage loan balance from your home’s appraised value. The result is your total home equity. Multiply that number by the max LTV ratio, and you get the upper limit of your borrowing amount.

For example, say your home is worth $425,000, you owe $200,000 on your mortgage and your lender allows a maximum LTV ratio of 80%. Here’s how you’d crunch the numbers:

Step 1: Subtract your mortgage loan balance from your home’s appraised value to find your home equity.

$425,000 – $200,000 = $225,000

Step 2: Multiply the result by the lender’s max LTV ratio to find the maximum loan limit.

$225,000 x 0.80 = $180,000

In this example, you could potentially borrow up to $180,000 with a cash-out refinance. Factors like a lower credit score or a higher debt-to-income (DTI) ratio may decrease the amount you can tap.

Cash-Out Refinance Requirements

The cash-out eligibility requirements vary by loan type. Here are the criteria for the major home loan programs:

Credit Score

With a conventional loan, you may qualify for a cash-out refinance with a credit score of at least 640. The minimum rises to 660 or 680 based on factors like your home equity, DTI ratio and the number of units in your property.

FHA loans require a credit score of at least 500 or 580 for a cash-out refinance, though many lenders require a higher score. VA loans don’t come with a specific minimum.

Debt-to-Income Ratio

Your DTI ratio shows lenders how much of your monthly income goes toward paying off debts. This information helps lenders determine whether you can comfortably afford a higher monthly mortgage payment.

For example, if you earn $10,000 a month before taxes and you pay $3,500 per month toward debts, then your DTI ratio is 35% ($3,500 / $10,000 = 35%).

With a conventional cash-out refinance, your total debt (including the mortgage payment) should account for no more than 45% of your pre-tax income. You’ll need to show you have a certain amount of cash reserves if your DTI ratio is any higher. FHA loans set a maximum DTI ratio of 50%, while VA loans put it at 41%.

Home Equity

Lenders usually prefer that you keep some equity in your home after you take out your loan. The requirement varies with each lender and mortgage program, but it often ranges from 20% to 30%.

You’ll typically see the limit written as a maximum LTV ratio. For instance, if your lender has a maximum 80% LTV ratio, your new mortgage balance can’t exceed 80% of your home’s value. That leaves 20% equity in your home after you do the cash-out refinance.

Seasoning Requirement

You’ll typically need to own your home for a certain period of time—known as the seasoning period—before you can do a cash-out refinance. Conventional loans require you to wait at least 12 months before applying for the cash-out refinance.

VA loan borrowers must wait at least 210 days, while FHA loan borrowers need to live in the home for at least 12 months before doing a cash-out refinance.

Cash Reserves

You may also need to show you have enough money in savings to cover mortgage payments in a financial emergency. These are known as cash reserves. If you’re doing a cash-out refinance on a conventional home loan and your DTI ratio exceeds 45%, then you’ll need at least six months’ worth of mortgage payments in your reserve. FHA loans don’t require reserves.

Pros and Cons of a Cash-Out Refinance

A cash-out refinance allows you to convert your home equity into cash, so these loans can be attractive when you need a large sum of money. They’re also cheaper compared to unsecured forms of lending, like credit cards and personal loans. But they increase your monthly mortgage payments and come with closing costs, so you’ll need to consider the pros and cons before moving forward.

Pros

• Allows you to access a large sum of money
• Provides predictable payments
• Interest rates may be lower compared to credit cards and personal loans

Cons

• Interest rates may be higher compared to a traditional mortgage
• Your monthly mortgage payments increase
• You’ll need to pay closing costs
• You drain the equity you’ve built over time

How to Get a Cash-Out Refinance

Here are steps you can take to compare cash-out refinance offers and apply for the loan:

Calculate your home equity. Start by estimating your home’s market value and finding your mortgage balance, then subtract the mortgage balance from the market value. For example, if your home is worth $425,000 and you have $200,000 remaining on your loan, you have $225,000 in home equity ($425,000 – $200,000 = $225,000).

Determine how much you can borrow. In general, you can borrow up to 80% of your home equity. Using the numbers in the previous example, you’d multiply $225,000 by 80% to see you may be able to borrow up to $180,000.

Shop rates from multiple lenders. Mortgage rates and eligibility criteria can vary widely between lenders, so it’s a good idea to get quotes from a mix of banks, credit unions and online lenders. Your loan offers will be based on your equity, the amount you want to borrow and your financial situation. Compare your options and use the information to negotiate with the lender you want to work with.

Check your budget. After researching cash-out refinance rates and eligibility criteria with several mortgage lenders, consider whether you can afford the higher payment that comes with a cash-out refi. You may decide to go with an alternative, such as a personal loan or a home equity loan, if the new loan will be too expensive.

Submit a mortgage application. If you decide to move forward with the cash-out refinance, you’ll submit a mortgage application and financial documents with the lender you choose. The underwriting process may take 30 days or more. Once you sign the loan papers, the lender typically pays off your original loan and deposits the excess cash into your bank account.

Is a Cash-Out Refinance a Good Idea?

The answer depends on the potential loan terms and your financial situation. Here’s how to tell whether a cash-out refi is a good idea:

When to Consider a Cash-Out Refinance

A cash-out refinance may be a good option if you qualify for a low interest rate and can comfortably afford the monthly payments. You’ll be in a stronger position if you also have cash reserves earmarked for financial emergencies.

Some financial experts suggest using these loans to get financially ahead somehow. For instance, when you use cash-out funds to pay for home renovations, you may automatically replenish some of the equity you drained in the process of refinancing. Or, you may use the money to consolidate high-interest debt.

When to Consider Your Alternatives

If mortgage rates have increased recently or you don’t qualify for a low rate, then you may deal with high borrowing costs. High monthly mortgage payments could strain your budget and increase your chances of defaulting on the loan. If this happens, you could lose your home to foreclosure. Instead of taking on an expensive home loan that you can’t afford, consider your alternatives:

• Home equity loan: A home equity loan is a second mortgage that allows you to borrow a lump sum of money using your home as collateral. This option may be ideal if rates are climbing, since you’ll only pay the higher rate on the home equity loan. The interest rate on your first mortgage stays intact.
• Home equity line of credit: A HELOC is a revolving line of credit you can borrow from as needed, so it offers a lot of flexibility. It’s another type of second mortgage that allows you to keep the interest rate on your first home loan.
• Rate-and-term refinance: Homeowners often choose a rate-and-term refinance if they can lock in a lower interest rate on a new home loan and don’t need to borrow cash.
• Personal loan: A personal loan is an unsecured loan that offers a lump sum of money with a fixed interest rate and installment payments. Interest rates may be higher compared to cash-out refinances or home equity products, but they won’t put your property at risk of foreclosure.