How a Cash-Out Refinance Works
Over time, you build home equity as you make mortgage payments and as your property’s value increases. Equity is the difference between your home’s current market value and your outstanding mortgage balance. A cash-out refinance allows you to borrow against this value.
Most lenders require you to maintain at least 20% equity in your home after the transaction. This means you can typically borrow up to 80% of your home’s value, which is known as the loan-to-value (LTV) ratio.
Here is a simple example:
- Home Value: $450,000
- Existing Mortgage Balance: $220,000
- Maximum Loan Amount (80% LTV): $360,000
- Potential Cash-Out Amount: $360,000 – $220,000 = $140,000
If you wanted to take out $50,000 in cash, you would apply for a new mortgage of $270,000 ($220,000 to pay off the old loan + $50,000 cash). At closing, your old mortgage is paid in full, you receive $50,000, and you begin making payments on the new $270,000 loan.
Common Uses for a Cash-Out Refinance
Homeowners often use the funds from a cash-out refinance for goals that can improve their overall financial situation. Common uses include:
- Home Improvements: Renovations like a kitchen remodel or basement finishing can increase your property value.
- Debt Consolidation: Paying off high-interest debts, such as credit card balances or personal loans, with a lower-interest mortgage loan can reduce your total interest payments.
- Education Expenses: You can use the funds to pay for college tuition or eliminate existing student loan debt.
- Major Investments: Some use the cash as a down payment on an investment property or to fund a new business venture.
Eligibility and Requirements
Lender requirements can vary, but they generally look for the following qualifications:
- Sufficient Home Equity: You typically must retain at least 20% equity in your home after the cash is taken out. Certain government-backed loans, like a VA loan, may allow for a higher LTV.
- Credit Score: Most conventional lenders require a minimum credit score of 620. A higher score often results in a better interest rate.
- Debt-to-Income (DTI) Ratio: Lenders prefer a debt-to-income (DTI) ratio below 43%, which shows that you can comfortably manage the new, higher mortgage payment.
- Stable Income: You will need to provide proof of consistent and reliable income through documents like pay stubs, W-2s, and tax returns.
Risks and Considerations
While a cash-out refinance is a useful financial tool, it comes with risks you must consider:
- Closing Costs: Like your original mortgage, a refinance comes with closing costs, typically ranging from 2% to 5% of the new loan amount.
- Longer Repayment Period: Your loan term resets, often to a new 15- or 30-year term. This could lead to paying more in total interest over the life of the loan.
- Increased Debt: Your home secures a larger loan balance. If you use the cash for depreciating assets or discretionary spending, you risk losing your home if you cannot make the payments.
Frequently Asked Questions (FAQ)
Is the cash from a cash-out refinance taxable?
Generally, no. According to the IRS, proceeds from a loan are not considered taxable income. However, the rules for deducting mortgage interest have changed. According to IRS Publication 936, you can only deduct interest on the portion of the loan used to “buy, build, or substantially improve” your home. Always consult a tax advisor for guidance on your specific situation.
What are the alternatives?
If a cash-out refinance isn’t the right fit, you could consider a home equity loan or a home equity line of credit (HELOC). These act as second mortgages, allowing you to borrow against your equity without replacing your current home loan. For more details, see the CFPB’s guide to mortgage options.
How is this different from a rate-and-term refinance?
A rate-and-term mortgage refinance simply changes the interest rate and/or the loan term of your existing mortgage. A cash-out refinance does this *plus* allows you to borrow a larger amount to receive cash from your home’s equity.