What Is a Cash-Out Refinance?

Do you have equity in your home and want to turn some of it into cash you can use for home repairs, investments, or other goals? If so, a cash-out refinance is likely one option on your radar. But what is a cash-out refinance, exactly?

Before you move forward, you need to know what a cash-out refinance is, how it works, and how it compares to other options, such as a home equity loan or home equity line of credit (HELOC). This helpful guide answers all of these important questions so you can decide which approach is the right fit based on your financial needs. 

What is a cash-out refinance?

A cash-out refinance involves refinancing your current home loan for more than you owe. The new loan pays off your old mortgage, and you receive the difference in a lump sum.

Let’s say your home is worth $400,000 and you owe $250,000. Lenders typically allow homeowners to refinance up to 80% of their home’s value, which would be $320,000 in this example. After paying off your existing balance, you could receive up to $70,000 in cash, minus closing costs.

A cash-out refinance is essentially a way to convert your home equity into cash by replacing your current mortgage with a larger one. Homeowners commonly use this arrangement to:

• Consolidate debt with a higher interest rate
• Fund home renovations
• Cover large expenses like medical bills or tuition
• Invest in other financial opportunities 

Since your home is used as collateral, the interest rate will be lower than that of an unsecured loan. You’ll pay whatever market mortgage interest rates are available at the time based on your credit score. The downside is that you’ll be repaying the amount you borrowed over a 30-year mortgage term. 

How does a cash-out refinance work?

Here’s how a cash-out refinance typically works:

• You apply for the loan
• The lender schedules an appraisal to determine the home’s current market value
• The lender calculates how much equity you have
• The lender approves a new loan amount based on your credit, income, and debt-to-income ratio (DTI)
• Your current mortgage is paid off
• You receive the remaining funds as a lump sum

Most lenders will cap you at 80% of your home’s value, while some may allow you to go up to 85%. That means you must leave some equity in the property. Since you’re refinancing, your old loan is completely paid off, meaning you’ll only have a single mortgage payment.

Cash-out refinance vs. home equity loan

A cash-out refinance replaces your existing mortgage with a new one. You’ll have one loan and one monthly payment.

By contrast, a home equity loan is a second mortgage. You’ll keep paying your original mortgage and take out an additional loan on top of it. That means you’ll have two monthly payments, which can be a lot for some homeowners to keep up with.

However, there are scenarios where a home equity loan makes more sense.

For example, if you have a low mortgage interest rate and refinancing would result in a much higher rate, you might consider a separate home equity loan. That way, you’ll only pay a higher rate on the smaller loan amount. Additionally, you can pay off the home equity loan early, which means long-term savings.

Cash-out refinance vs. HELOC

A home equity line of credit is also a second mortgage, but it functions a bit like a credit card. With a HELOC:

• You’re approved for a credit limit
• You borrow as needed during the draw period
• Rates can vary

If you need predictable payments and a fixed amount of cash, refinancing may be more appealing. If you want flexibility and access to funds over time, a HELOC might make more sense. 

Pros and cons of a cash-out refinance

There are benefits and risks to any financial product, including cash-out refinance mortgages. The advantages of a cash-out mortgage include:

• Lower interest rates compared to unsecured loans
• A single monthly payment
• Rate improvement if rates have dropped since you bought your home
• Access to a large sum of cash

The downsides include:

• Your home is at risk
• You’ll have to pay closing costs
• The repayment timeline is longer
• You’ll be increasing your mortgage balance

Before you move forward, consider whether the long-term cost outweighs the short-term benefits.

How does your credit score impact cash-out refinancing?

Applying for a cash-out refinance involves many of the same steps as applying for a new mortgage. You’ll have to provide the lender with pay stubs, W-2s, and a variety of other financial documents. Additionally, they’ll conduct a hard credit check to determine whether you qualify and what interest rate you’re eligible for. 

If you have a higher score and a low DTI, your odds of approval will be higher. Most lenders prefer a minimum credit score of 620 for refinancing. The better your score, the better your chances of accessing a low rate. 

Preparing for your application with Kikoff

If you’re ready to explore cash-out refinancing, it’s important to make sure your credit score is at or above the minimum threshold. Tools like Kikoff can help.

With Kikoff, you can access free dispute letter generation tools, report verified on-time rent payments, and take control of your financial future.

Start building a positive credit history with Kikoff.