What is a limited cash-out refinance and how does it work?

Homeowners typically refinance their mortgages for two main reasons: to save money or to tap their equity. Some use refinancing to get a lower interest rate, while others put their equity toward another expense, like home renovations.

If you’re thinking about refinancing your current mortgage, you have multiple refinance options to choose from, including a limited cash-out refinance. Keep reading for a closer look at what a limited cash-out refinance is, its benefits and drawbacks and how it can help you achieve other financial goals.

• What is a limited cash-out refinance and how does it work?
• Limited cash-out refinance vs. regular cash-out refinance
• Other types of refinancing
• Limited cash-out refinance pros and cons
• When does a limited cash-out refinance make sense?
• When does a no cash-out refinance make sense?

What is a limited cash-out refinance and how does it work?

A limited cash-out refinance uses a new loan to replace your existing mortgage. The new loan may have a lower interest rate, a different term length or both. Most lenders base eligibility for a limited cash-out refinance on the same factors as traditional mortgage loans, such as:

• Credit score
• Debt-to-income ratio
• Credit history
• Loan-to-value ratio

If you’re approved, you can also receive a limited amount of cash back that's no higher than either 2% or $2,000 of the new loan balance, whichever is lower (this rule is set by Fannie Mae guidelines). Keep in mind that while a lower interest rate or shorter term length will save you money over time, a limited cash-out refinance loan is larger than the initial loan amount. This is because all refinancing costs, like closing costs, are added to the new loan balance.

How much does a limited cash-out refinance cost?

Fees associated with a limited cash-out refinance will vary depending on your original loan balance, all refinance costs and the final amount totaled in your new loan.

Refinancing costs can include:

• Unpaid property taxes
• Title, recording and other fees associated with closing costs
• Escrow expenses
• The full payoff amount for your original mortgage

Limited cash-out refinance vs. regular cash-out refinance

A regular cash-out refinance is similar to a limited cash-out refinance in that you can use both types of refinance loans to pay off an existing home loan. But depending on how much equity you have in your home, you can receive a substantially larger amount of money in cash with a standard cash-out refinance. Your new loan will be larger than your original loan, but you’ll pocket the difference in cash.

In contrast, a borrower only receives a maximum of 2% or $2,000 in cash when choosing a limited cash-out refinance loan.

Other types of refinancing

Standard and limited cash-out refinance loans aren’t your only options. You may also consider these other types of refinancing loans:

• No cash-out refinance — Also known as a rate-and-term refinance, a no cash-out refinance replaces your existing loan with an equal or lower loan amount. This is a smart option if you want a lower interest rate or different term length but don’t want to receive cash in hand.
• Cash-in refinance — A cash-in refinance allows you to refinance your existing loan while also paying a large sum toward the principal before closing. You can use this option to potentially lower your rate and monthly payment.
• FHA streamline refinance — FHA streamline refinance loans involve refinancing existing FHA-insured loans. You can only use this option if you’re an existing FHA borrower, the cash back you’ll receive is minimal and the new loan doesn’t exceed the original mortgage amount.

Limited cash-out refinance pros and cons

Limited cash-out refinancing has pros and cons that you should consider before applying.

Pros of a limited cash-out refinance

• You may receive better terms on your new loan. A limited cash-out refinance may allow you to qualify for a lower interest rate or shorter loan term. This is especially true if national loan rate averages have decreased or if your credit score or debt-to-income ratio has positively changed.
• You can increase your loan amount to cover closing costs. Instead of dipping into your savings to pay closing costs, you can roll them into the new loan balance. Keep in mind, this increases the amount you have to repay.
• You can receive up to $2,000 in cash. The limited cash-out option enables you to receive a small amount of cash without taking out a much larger loan.

Cons of a limited cash-out refinance

• You’re using your home as collateral. This new loan uses your property as collateral, so if you’re unable to make your payments, your lender can seize your home.
• You may increase your interest rate. Until the new loan is processed, there’s no guarantee that you’ll receive a lower interest rate on the new loan. Depending on your financial history and current average loan rates, you may receive a higher interest rate on the new loan.
• Your monthly payment may be higher. When closing costs, associated fees and the cash-out option are all included in the total balance, your overall monthly payment can be higher than your original loan.

When does a limited cash-out refinance make sense?

A limited cash-out refinance can be the most beneficial option if you find yourself in one of these situations:

• You need some cash. With a maximum of $2,000 in cash, you can fund other expenses, such as home renovations or repairs.
• You don’t want to take out a home equity loan. A home equity loan is an additional mortgage which then becomes a second lien on your property. But a refinance leaves you with a single loan and payment.
• You don’t want to pay closing costs out of pocket. You can roll your closing costs into the new loan balance and pay this amount off over the course of the loan.

When does a no cash-out refinance make sense?

A limited cash-out refinance loan may not be the right option for your needs. Consider these common scenarios in which your financial goals can be met more comfortably with a no cash-out refinance:

• You have limited equity in your home. If you have limited equity in your home, you may find it easier to qualify for a no cash-out refinance compared to a limited cash-out refinance.
• You want to transition to a new loan type. If your original mortgage was an FHA loan or an adjustable-rate mortgage, transitioning to a conventional loan with a fixed-rate mortgage can ensure your monthly payments will stay the same over time.
• You want to lower your interest rate and loan term without taking out significant cash. Not all refinancing options force you to take out high cash amounts. A no cash-out refinance can provide better terms, allow you to keep your existing loan amount and permit you to pay closing costs out of pocket — all without getting any money "back."