What to know about getting a cash-out refinance on a paid-off home

Paying off your mortgage and saying goodbye to monthly mortgage payments is exciting. It means you own your home outright and have more money in your monthly budget for other expenses.

But if you need cash for a home renovation, college costs, or other major expenses, you may consider a cash-out refinance when you’ve already paid off your home. Taking out a new mortgage is a big decision with risk involved, so you should consider it carefully. If you’re considering refinancing your mortgage, it’s a good idea to compare rates from multiple lenders. With Credible, you can see personalized rates in minutes.

• What is a cash-out refinance?
• Can you get a cash-out refinance on a paid-off home?
• How does a cash-out refinance work on a paid-off home?
• How much can you get from a cash-out refinance?
• Pros and cons of a cash-out refinance on a paid-off home
• Is a cash-out refinance right for you?
• What to consider before getting a cash-out refinance on a paid-off home
• Other ways to borrow against your paid-off home

What is a cash-out refinance?

A cash-out refinance is a type of home loan that typically lets you access your home equity by replacing your existing mortgage with a new one. The new home loan has a higher loan amount and may have a different interest rate and loan term.

You have many options when you do a cash-out refinance, including conventional loans, FHA loans, and loans backed by the Department of Veterans Affairs (VA loans). Different loan types have different rates and fees, so it’s important to shop around to find the best loan for you.

Can you get a cash-out refinance on a paid-off home?

Yes, you can. A cash-out refinance loan usually involves taking out a new loan to pay off your existing mortgage and taking some of your equity out in cash. When you do a cash-out refinance on a paid-off home, you don’t have an existing mortgage to pay off. This actually gives you an advantage when it comes to refinancing, because you have more equity in your home.

Lenders typically won’t let you borrow more than 80% of your home’s equity with a cash-out refinance.

For example, if your home is worth $400,000 and your current mortgage balance is $320,000, your loan-to-value (LTV) ratio is already 80%. So you may have a hard time finding a lender willing to approve a cash-out refinance.

But if your home is worth $400,000 and you’ve paid off your mortgage, you could borrow up to $320,000 before running into that 80% maximum LTV ratio.

How does a cash-out refinance work on a paid-off home?

Refinancing a paid-off home is similar to applying for any other type of mortgage or refinance. You have to apply for the loan and meet the lender’s debt, income, and credit requirements.

While those requirements vary by lender, one common condition is your debt-to-income (DTI) ratio. Generally, it must be no higher than 43% — including your new mortgage payment.

Your DTI ratio is all your monthly debt payments divided by your gross monthly income. For example, if your monthly income is $6,000 and your total monthly debt payments are $2,000, your DTI ratio is 33%.

Since you own your home free and clear, you don’t have to worry about an existing mortgage affecting your DTI ratio. But if you have other debts, such as credit card debt, car loans, or student loans, lenders will factor those payments in when evaluating your application.

If the lender approves your application, it will schedule the closing. At the closing, you can expect a very similar experience to closing on your original home loan — mostly signing a lot of paperwork.

You typically receive a check for the funds three to five days after closing.

How much can you get from a cash-out refinance?

How much you can get from a cash-out refinance depends on how much your home is worth and the lender’s requirements.

As previously mentioned, conventional loans typically won’t allow you to borrow more than 80% of your home’s value. But other loan programs may let you borrow more. For example, the VA will guarantee loans up to 100% of your home’s value with a VA cash-out refinance.

While your lender will likely require an appraisal to determine your home’s value, you can get an estimate of how much you can borrow by looking up the market value of your home on an online real estate site, such as Realtor.com, Redfin, or Zillow.

For example, if you estimate that your home is worth $350,000, you can borrow up to $280,000 through a conventional loan or $350,000 through a VA loan.

Just keep in mind that this is a rough estimate. Your lender will be able to provide a more accurate estimate of your home’s value and how much it’s willing to lend.

Pros and cons of a cash-out refinance on a paid-off home

Taking out a cash-out refinance on a paid-off home comes with upsides and downsides. A few reasons to consider (or reconsider) this home equity option include:

Pros

• Low-cost financing for home renovations — Repairing, updating, and renovating your home helps keep your home comfortable and inviting and can build additional equity. A cash-out refinance allows you to borrow against your home’s equity to fund home improvements — usually with a much lower interest rate than financing those improvements with a credit card or personal loan.
• Potential tax deduction — If you use the funds from a cash-out refinance to renovate or remodel your home, you may be able to claim the mortgage interest you pay as an itemized deduction and lower your tax bill.
• Debt consolidation — You can also use a cash-out refinance to pay off other high-interest loans. This can potentially save you thousands of dollars in interest, help you get out of debt faster, and improve your credit score by lowering your credit utilization ratio.

Cons

• Risk of foreclosure — Your home serves as collateral for any kind of mortgage, so if you run into financial troubles and can’t make payments, you risk losing your home.
• Closing costs — You pay closing costs for a cash-out refinance, just as you would with any other mortgage. Closing costs typically range anywhere from 2% to 5% of the loan amount. Some of those costs are negotiable and some aren’t, so it’s important to shop around and compare rates and terms from several lenders to ensure you’re getting the best deal available to you.
• Lengthy process — Tapping your home’s equity typically isn’t an option when you need cash quickly. The loan underwriting process usually takes 30 to 45 days. During that time, you have to be ready to respond promptly to requests for additional information or documentation from the loan underwriter.

Is a cash-out refinance right for you?

Cash-out refinancing can be a good option for many people, but it isn’t the best choice in every situation. Here are some instances when a cash-out refi on a paid-off home might make sense, and some examples of when it doesn’t.

A cash-out refinance might be a good move when:

• You want to use the loan funds for home improvements that’ll increase your home’s value, or repairs that will preserve your home and its value.
• You want to tap your home’s equity to purchase an investment that’ll generate returns that are higher than the interest rate you’ll pay on the loan — and you can comfortably tolerate the inherent risk of investing.
• You can save a significant amount of interest by refinancing other high-interest debts with a cash-out refinance.

A cash-out refinance might not be the best choice when:

• You need money immediately for an emergency.
• You’re struggling with debt and may have trouble making your mortgage payments.
• You want to use your home equity to purchase unnecessary luxuries, like an expensive car, electronics, or a vacation.

What to consider before getting a cash-out refinance on a paid-off home

When you take out a mortgage on a property that’s paid off, you’re taking the risk that you could lose the home if you can’t make your mortgage payments for some reason.

Before taking out a cash-out refinance on a paid-off home, consider the following to see whether the benefits outweigh the risks:

• How do you plan to use the equity? It might be worth the risk to tap your home equity to pay for improvements that’ll increase the value of your home. But if you plan on using the money to refinance unsecured debts or purchase items that’ll decrease in value, you may be better off looking at an alternative arrangement that won’t put your home at risk.
• Can you afford the monthly payment? If you’ve been mortgage-free for a while, you’ve probably gotten used to having more room in your budget for travel, entertainment, shopping, and dining out. Having a mortgage payment can significantly impact the amount of money you have available to spend each month, so make sure it fits into your budget and overall financial goals.
• How much do you need to borrow? Every mortgage comes with closing costs, and those costs can significantly increase the cost of borrowing. For that reason, a cash-out refinance might not be the best option for minor expenses you may be able to cover with a personal loan, credit card, or savings.
• Will you qualify for a good interest rate? Your credit history, debt-to-income ratio, and other financial elements affect the mortgage rate you’ll get. If you have a poor credit score or other financial issues, you may not qualify for a reasonable interest rate.

Other ways to borrow against your paid-off home

A cash-out refinance isn’t the only way to borrow against your home’s equity. Consider these other options:

• Home equity line of credit — A HELOC is an adjustable-rate mortgage that allows you to borrow against your home equity with a revolving line of credit, similar to a credit card. This can be a good option if you need to borrow smaller amounts over several years rather than one lump sum.
• Home equity loan — A home equity loan also allows you to borrow against your home’s equity. You receive a lump sum upfront and repay the loan in fixed monthly payments.
• Personal loan — Personal loans are shorter-term loans that you can use for virtually any purpose.
• Reverse mortgage — A reverse mortgage allows homeowners ages 62 and older to access the equity in their homes. You don’t have to repay the loan as long as you live in the house, keep it in good condition, and continue paying your property taxes and homeowners insurance premiums.