What Is a Cash-Out Refinance?

A cash-out refinance replaces your current mortgage with a larger one and gives you the difference in cash, minus closing costs and any amounts paid off through the transaction. It can turn part of your home equity into money for renovations, debt consolidation, tuition, medical bills, or another large expense.

That flexibility comes with a serious tradeoff: You are borrowing more against your home. Before moving forward, compare the new mortgage with a home equity loan or home equity line of credit (HELOC) and look at the total cost, not just the cash you would receive.

How does a cash-out refinance work?

Home equity is the difference between your home's current value and the debt secured by it. With a cash-out refinance, the new loan pays off your existing first mortgage. You receive the remaining proceeds after closing costs and any other required payoffs.

For example, say your home is worth $400,000 and you owe $250,000. For a conventional cash-out refinance on a one-unit primary residence, Fannie Mae's standard maximum loan-to-value ratio is 80%, although limits differ by property and loan program.

At an 80% limit, the largest new loan in this example would be $320,000:

• New loan: $320,000
• Existing mortgage payoff: $250,000
• Difference: $70,000
• Cash received: up to $70,000, minus closing costs and any other amounts paid at closing

The actual amount available depends on the appraisal, the lender's program, your qualifications, existing liens, and closing costs.

Your home secures the new loan. If the new payment becomes unaffordable and you fall behind, you could face foreclosure. Borrowing against your home to pay unsecured debt can also turn debt that did not directly put your home at risk into mortgage debt that does.

Read more >> How Soon Can You Refinance Your House?

What happens during the application process?

A cash-out refinance is a new mortgage application, not a withdrawal from a savings account. The process typically looks like this:

1. You apply with a mortgage lender.
2. The lender reviews your credit, income, assets, debts, and property information.
3. The lender determines the home's value, often through an appraisal.
4. You receive a Loan Estimate showing the proposed rate, monthly payment, closing costs, and cash to close.
5. If the loan is approved and you close, the new mortgage pays off the old one.
6. You receive the remaining proceeds, generally as a lump sum.

For most mortgages, the lender must provide a Loan Estimate within three business days of receiving an application. Compare estimates from multiple lenders using the same loan amount and term. Check the annual percentage rate (APR), closing costs, monthly payment, and total interest rather than focusing on the interest rate alone.

Your new loan does not have to use the same term as your old one. Starting a new 30-year mortgage may lower the required monthly payment but extend how long you carry the debt. A shorter term may reduce total interest but require a higher payment.

Cash-out refinance vs. home equity loan

A cash-out refinance replaces your first mortgage, so you have one mortgage payment and a new rate and term on the entire balance.

A home equity loan is usually a second mortgage. You keep your original mortgage and borrow a fixed lump sum against your equity, creating a separate payment. It may make more sense when you want a set amount and do not want to replace a favorable rate on your existing mortgage.

Neither option is automatically cheaper. Compare the rates, fees, repayment periods, and total borrowing costs. Because both use your home as collateral, falling behind can put your home at risk.

Cash-out refinance vs. HELOC

A HELOC is a revolving line of credit secured by your home. During the draw period, you can generally borrow as needed up to your limit and repay what you use. After that, you enter a repayment period and cannot make additional draws.

According to the Consumer Financial Protection Bureau, HELOCs usually have variable interest rates, so payments may change. Some plans offer a fixed-rate conversion for part or all of the balance.

A cash-out refinance may fit better when you need one lump sum and replacing your current mortgage still makes financial sense. A HELOC may fit better when expenses will happen over time and you want to borrow only what you need. Review the draw period, repayment period, rate structure, fees, minimum draws, and potential payment changes before choosing.

Read more >> What Is a HELOC and How Does It Work?

Pros and cons of a cash-out refinance

A cash-out refinance can be useful, but the right choice depends on the new loan terms and what you plan to do with the money.

Potential advantages include:

• Access to a lump sum without adding a separate second-mortgage payment
• A rate that may be lower than some unsecured borrowing options
• The ability to switch mortgage terms or move between a fixed and adjustable rate
• A possible lower mortgage rate if current offers are better than your existing loan

Potential disadvantages include:

• A larger mortgage balance and less home equity
• Closing costs and other fees
• A higher rate on your entire mortgage if your current loan has a lower rate
• More total interest if you restart or extend the repayment timeline
• Foreclosure risk if you cannot make the new payments

Using the proceeds to consolidate higher-interest debt does not erase the debt. It moves the balance into a loan secured by your home. The CFPB recommends comparing the new mortgage's interest and origination costs with the cost of keeping your current mortgage and paying the other debts separately. If debt payments are already hard to manage, consider talking with a nonprofit credit counselor before putting your home on the line.

How does your credit affect a cash-out refinance?

There is no single minimum credit score for every cash-out refinance. Requirements vary by lender, loan program, property type, loan-to-value ratio, and other parts of your application.

Your credit score and credit report can affect both approval and the rate you are offered. Lenders also consider your income, assets, existing debts, and payment history. In general, higher credit scores can make borrowers eligible for lower mortgage rates, but your score is only one part of the decision.

Before applying, review your credit reports and dispute inaccurate information. Then request comparable offers from several lenders. Shopping by rate alone can hide important differences in fees and long-term cost.

Read more >> How to Refinance a Mortgage With Bad Credit

Bottom line

A cash-out refinance can convert home equity into a lump sum, but it also replaces your current mortgage, changes your rate and term, and increases the debt secured by your home. Compare it with a home equity loan and HELOC, and use Loan Estimates to review the full cost before deciding.

If you plan to refinance later, building a positive credit history now can give lenders more information to evaluate. Kikoff's Credit Account reports payment activity to the major credit bureaus and does not require a hard credit check to sign up. Kikoff does not determine whether you qualify for a mortgage or what rate a lender offers.