Reasons for a cash-out refinance

If you need money, using the equity you have built up in your home to get a cash-out refinance can be a cost-effective way to get funds. Despite recent increases, mortgage refinance rates are still generally lower than rates for many other types of credit, including credit cards and personal loans.

But a cash-out refinance also comes with closing costs and risks, so you should be sure the benefits of borrowing this way outweigh the potential downsides. Let’s look at how cash-out refinancing works, when it makes sense, and when it might not.

• How cash-out refinancing works
• How much cash can you take out of your home?
• 7 ways to use your cash-out refinance
• Other ways to tap your home equity

How cash-out refinancing works

A cash-out refinance replaces your current mortgage with a new, larger mortgage. The difference between the two amounts goes to you as cash back at closing, which you can then use for anything you want. As long as you have equity in your home, you may be eligible for a cash-out refinance.

Lenders base your eligibility on several factors:

• Your credit score — The higher your credit score, the lower your interest rate on your cash-out refi.
• Your home appraisal value — Some lenders require an on-site appraisal of your home's interior and exterior, while others require only a drive-by.
• Loan-to-value (LTV) ratio — This is the outstanding principal balance of the current mortgage versus the current appraised value of your home.
• The age of your mortgage — Some lenders only allow you to apply for a cash-out refi if your mortgage is at least 12 months old.

How much cash can you take out of your home?

Multiple factors affect how much you can take out of your home with a cash-out refinance. With a conventional cash-out refinance, you can borrow up to 80% of the value of your home — this is referred to as "loan-to-value ratio," or LTV. Keep in mind that the percentage required often depends on the lender and whether you’re willing or required to pay for private mortgage insurance (PMI) on the new loan.

Before determining the maximum amount you can cash out, you must subtract the balance owed on your current mortgage.

Here’s an example:

• Home value: $550,000
• Maximum withdrawal (80%): $440,000 ($550,000 x 0.80)
• Current mortgage balance: $300,000
• Maximum cash-out amount: $140,000 ($440,000 - $300,000)

The requirements for VA and FHA cash-out refinances are somewhat different:

• VA loans — A VA cash-out refinance lets you borrow up to 100% of your home’s value, although some lenders limit the LTV to 90%. Available to active-duty service members, National Guard and Reserve members, veterans, and many surviving spouses, these loans often charge fees, unless you have a disability from a service-related accident.
• FHA loans — An FHA cash-out refinance comes with an annual mortgage insurance fee and other upfront fees, and you can only borrow up to 80% of your home’s LTV. You may also need a credit score of at least 600 to qualify.

WHAT IS PRIVATE MORTGAGE INSURANCE AND HOW DOES IT WORK?

7 ways to use your cash-out refinance

It makes sense to use a cash-out refinance for many things. But some purposes come with higher costs and risks than others, so you should consider the pros and cons carefully.

1. Financing home improvement projects

Makes sense if: The home improvement will increase your home’s value.

Financing home improvement or remodeling projects can add value to your home, so it may make sense to use a cash-out refinance to fund the project.

For example, a minor kitchen remodel costs an average of $28,279 and recoups more than 71% of the investment at resale, according to Remodeling Magazine’s 2022 Cost vs. Value Report. You could use a personal loan to pay for the project, but personal loan rates are typically much higher than mortgage rates.

However, renovation projects can be expensive, so make sure you can afford the payments.

2. Paying off credit card debt

Makes sense if: You can realize interest savings and manage the new payments.

Credit card debt is unsecured, meaning if you default on your payments, you won’t lose your home. However, when using a cash-out refi to pay off your credit cards, you roll the debt into your home. If you default, your home is at risk.

Mortgage interest rates are typically much lower than credit card rates, so using a cash-out refinance could significantly reduce the total interest you’ll pay on the debt. Just be sure you can manage the monthly mortgage payment and that the savings are worth the added risk to your home.

HOW DOES DEBT CONSOLIDATION WORK?

3. Paying down student loans

Makes sense if: You have private student loans at very high interest rates.

Because federal student loans generally have lower interest, flexible repayment terms, and provide access to loan forgiveness programs, it’s rarely a good idea to use a cash-out refinance to pay them off. But if you have high-interest private student loans, or private student loans with unmanageable monthly payment amounts, a cash-out refinance can be a way to reduce costs and get a lower payment.

Keep in mind, though, that if you use a 30-year cash-out refinance to pay off a 10-year student loan, you could end up paying more in interest in the long run. And, as with paying off credit card debt, using a cash-out refinance to pay off student loan debt turns that unsecured debt into one secured by your home.

4. Paying for a child's college education

Makes sense if: You’ve fully tapped federal student loans, have plenty of equity, and can manage the monthly payment.

With the rising cost of college, not many people have the total cost to attend set aside for their children. A cash-out refi that uses your home’s equity can be a way to fund an education without taking out multiple student loans.

But keep in mind, you’ll need to have sufficient equity. In a 2021 report by CollegeBoard, the average cost to attend an in-state four-year public university was $27,330. Out-of-state tuition for a four-year public university was $44,150 on average. If you don’t have that kind of equity in your home, you may not qualify for a cash-out refi.

HOW TO DECIDE WHICH STUDENT LOANS TO PAY OFF FIRST

5. Paying for investments

Not recommended for most homeowners

Making an investment — whether the stock market, real estate, or cryptocurrency — can turn the cash you get from a cash-out refi into more money in the long run.

But keep in mind that this isn’t recommended for most people, since investing is already a complex and risky prospect. Proceed with caution if you’re going to do this.

6. Buying an investment property

Makes sense if: You have ample equity in your home and can recoup your costs through income from the investment property.

Investment properties tend to increase in value over time, and they offer the potential for income. They also offer tax advantages, like possibly deducting mortgage interest, property insurance, and property management fees. But investing in property can be expensive, and there’s still a financial risk.

7. Covering emergency expenses

Not recommended in most cases

Many Americans have little or no emergency funds. Because a cash-out refinance involves a closing process that’s much like the one you went through when you bought your home, refinancing may not get you the cash you need quickly enough.

A personal loan may be a better option to cover emergencies since many online lenders can fund loans in a few days after approval. Some even promise next-day funding.

Some emergencies, like a trip to the emergency room, may be covered (or partially covered) by insurance. Or, the provider may have an optional payment plan available and charge little or no interest. You can also try negotiating any steep medical bills to help bring the cost down.

HOW DO I BUILD AN EMERGENCY FUND?

Other ways to tap your home equity

In addition to a cash-out refinance, you have other options for tapping your home equity.

Home equity loan

Best for getting the cash you need without affecting your current mortgage

Like a cash-out refinance, a home equity loan lets you borrow against your home’s equity. However, instead of replacing your current mortgage, a home equity loan is a second mortgage. You borrow the cash you need, and your current mortgage remains untouched.

Closing costs for a home equity loan can be lower because you're borrowing less than you might with a cash-out refinance. And you won’t lose ground on your first mortgage.

Home equity line of credit (HELOC)

Best for only borrowing what you need

A home equity line of credit is a lot like a credit card — you only borrow what you need, and you only pay interest on the amount you borrow. Instead of borrowing a large amount all at once, you can borrow smaller amounts when needed — as long as you do so during the loan’s draw period. When the draw period ends, you’ll repay only what you borrowed, along with interest.

Interest rates vary but may be lower than with a home equity loan.

Reverse mortgage

Best for people over the age of 62

If you need money to cover healthcare expenses, pay off your mortgage, or add to your income, you might consider a reverse mortgage — a type of loan secured by your home. It allows you to keep your home but convert part of the equity into cash. However, if you can’t keep up with basic home maintenance, property taxes, or insurance, your lender can call for your loan to be due and payable in full.

Limited cash-out refinance

Best for homeowners who only need up to $2,000

A limited cash-out refinance replaces your existing mortgage with a new one. But unlike a traditional cash-out refinance, the cash you receive from a limited cash-out refi doesn’t come from the equity in your home.

Instead, it’s an amount equal to or less than your current outstanding mortgage balance. Plus, the cash you receive can’t be higher than $2,000 or 2% of the new loan balance, whichever is less, according to Fannie Mae guidelines.