Cash-Out Refinancing: Unlock Home Equity and When to Refinance

What Is a Cash-Out Refinance?

Cash-out refinancing lets homeowners convert part of their home equity into cash by replacing their current mortgage with a larger one. The difference between the two loans is paid out in cash, which they can use for home improvements, debt consolidation, or education costs. While it can be a useful financial tool, borrowers should consider the risks, like higher monthly payments or longer loan terms, and ensure they meet lender eligibility requirements. Factors like your home value, equity, and current interest rates determine whether a cash-out refinance makes sense

Understanding the Cash-Out Refinance Process

A cash-out refinance allows you to use your home as collateral for a new loan, creating a new mortgage for a larger amount than currently owed. The new mortgage pays off your previous, smaller mortgage balance, and you get paid the difference in cash.

With a standard refinance, the borrower would never see any cash in hand. Refinancing is a popular process for replacing an existing mortgage with a new one that extends more favorable terms to the borrower. Refinancing a mortgage can help you lower your interest rate, decrease your monthly mortgage payments, shorten or extend the loan's term, and remove or add borrowers.

However, a cash-out refinance increases your loan balance and monthly payment since you're withdrawing your home's equity to access cash at the loan's closing.

Assessing Your Cash Needs With a Cash-Out Refinance

The funds from a cash-out refinance can be used as the borrower sees fit, but many typically use the money to pay for big expenses such as medical or educational fees, to consolidate debt, or as an emergency fund.

Using home equity is a simple way to get funds for emergencies, expenses, or debt consolidation. But borrowing more increases debt and monthly payments, so assess your cash needs carefully. With a cash-out refinance, you need to balance the need for cash with your ability to repay a larger mortgage loan.

Choosing the Right Lender for Your Cash-Out Refinance

Look for a lender who will work with you for a cash-out refinance. The lender reviews your current mortgage terms, loan payoff balance, and credit profile. The lender makes an offer based on an underwriting analysis. The borrower gets a new loan that pays off their previous one and locks them into a new monthly installment plan. The amount above and beyond the mortgage payoff gets paid to the borrower in cash.

Impact on Home Equity After a Cash-Out Refinance

A cash-out refinance reduces your home equity and increases your mortgage debt. This raises lender risk, possibly resulting in higher closing costs, fees, or interest rates compared to a standard refinance. Borrowers with specialty mortgages like U.S. Department of Veterans Affairs (VA) loans, including cash-out loans, can often be refinanced through more favorable terms with lower fees and rates than non-VA loans.

Weighing the Pros and Cons of Cash-Out Refinancing

A cash-out refinance can offer many benefits to homeowners. However, it's important to evaluate the pros and cons and weigh the benefits of converting equity into cash with the risks associated with taking out a new mortgage loan.

Pros

Lower Interest Rate

The cash-out refinance gives the borrower all of the benefits of a standard refinance, including a potentially lower rate and other beneficial modifications. Savvy investors who monitor interest rates over time typically jump at the chance to refinance when mortgage rates have fallen.

Improve Your Finances and Credit

If the funds from the cash-out refinance are used to pay off credit card debt or personal loans, borrowers can save money on the debt servicing costs due to the mortgage loan's lower interest rate. Also, your finances can improve if the new loan consolidates debt, reducing the number of loan and credit card payments. As a result, you might improve your credit score.

Money for Purchase or Debt Consolidation

Borrowers can use the funds from a cash-out refinance to pay down high-rate debt or fund a large purchase. This option can be particularly beneficial when rates are low or in times of crisis—such as in 2020–21, in the wake of global lockdowns and quarantines, when lower payments and some extra cash may have been very helpful.

Cons

Closing Costs and Fees

There can be a variety of different types of refinancing options, but in general, most will come with several added costs and fees that make the timing of a mortgage loan refinancing just as important as the decision to refinance.

Higher Debt and Monthly Payments

Consider why you need the cash to ensure that refinancing is your best option. A cash-out refinance may come with a lower interest rate than borrowing via unsecured debt, like credit cards or personal loans. However, you're taking out a larger mortgage loan with higher monthly payments unless you increase the loan's term length. You must have the financial viability to make the payments for many years.

Risk of Losing Your Home

Unlike a credit card or personal loan, with a cash-out refinance, you risk losing your home if you can’t repay the mortgage. Carefully consider whether the cash you withdraw from your home's equity is worth the risk of losing your home if you can’t keep up with payments in the future.

With a cash-out refinance, unlike credit cards or personal loans, you risk losing your home if you can’t repay. Consider if accessing this cash is worth the risk of foreclosure

For example, if your home's value decreases, you could end up underwater on your mortgage, meaning you owe more than the house is worth. If you experience job loss or a decreased income, your new, higher monthly payment might become unaffordable. If you fall behind in your payments and default on the loan, the lender could foreclose on the property, repossess the home, and resell it.

Example of Cash-Out Refinancing

Say you took out a $200,000 mortgage to buy a property worth $300,000, and after many years, you still owe $100,000. If your property is still valued at $300,000, you have $200,000 in home equity. With lower rates, you might be approved for up to 80% of your home's equity.

Loan-to-value of 80%

Let’s say your lender will lend you 80% of your home’s value. Your cash-out refinance would have the following financial details:

• New loan: $240,000 ($300,000 home value * .80 loan-to-value)

The loan proceeds would be divided as:

• Take $100,000 and pay off the existing mortgage loan balance
• Receive $140,000 as a lump-sum cash payment

As a result, the new mortgage loan of $240,000 would consist of the $100,000 from the original loan's remaining balance plus the $140,000 you received as cash.

Loan-to-value of 50%

Let’s say that although your lender will lend you 80% of your home’s value, you only want $50,000. Your cash-out refinance would have the following financial details:

• New loan: $150,000 ($300,000 home value * .50 loan-to-value)

The loan proceeds would be divided as:

• Take $100,000 and pay off the existing mortgage loan balance
• Receive $50,000 as a lump-sum cash payment

As a result, the new mortgage loan of $150,000 would consist of the $100,000 from the original loan's remaining balance plus the $50,000 you received as cash.

The disadvantage of the cash-out refinance includes the new lien on your home for the larger mortgage loan balance since it includes the original loan amount and the cash amount. However, you don't need to take on the added risk and higher mortgage loan payments at an 80% loan-to-value. You can opt for a lower lump-sum payment, which can help ensure you can repay the loan.

Comparing Rate-and-Term With Cash-Out Refinancing

Borrowers have a variety of options when it comes to refinancing. The most basic mortgage loan refinance is rate-and-term refinance, also called no cash-out refinancing. With this type, you are attempting to attain a lower interest rate or adjust the term of your loan, but nothing else changes on your mortgage.

For example, if your property was purchased years ago when rates were higher, you might find it advantageous to refinance to take advantage of lower interest rates. In addition, variables may have changed in your life, allowing you to handle a 15-year mortgage, saving on the loan's total interest but forgoing the lower monthly payments of your 30-year mortgage. In other words, with a rate-and-term refinance, nothing else changes, just the rate and term.

Cash-out refinancing has a different goal. You receive the difference between the two loans in tax-free cash. This is possible because you only owe the lending institution the original mortgage amount. Any extraneous loan amount from the refinanced, cash-out mortgage is paid to you in cash at closing, which is generally 45 to 60 days from when you apply.

Compared to rate-and-term, cash-out loans usually come with higher interest rates and other costs, such as points. Cash-out loans are more complex than a rate-and-term and usually face more extensive underwriting standards. A high credit score and a lower relative loan-to-value (LTV) ratio can mitigate some concerns and help you get a more favorable deal.

Cash-Out Refinancing vs. Home Equity Loans: Key Differences

In a cash-out refinance, you settle your current mortgage and start a new one. A home equity loan adds a second mortgage to the first, resulting in two liens on your home. This could translate to having two separate creditors, each with a possible claim on your home.

Closing costs on a home equity loan are generally less than those for a cash-out refinance. Home equity credit can be advantageous if you need a substantial sum for a specific purpose. However, the refinance might make sense if you can get a lower interest rate with a cash-out refinance—and if you plan to stay in your home long-term. In both cases, make sure you can repay the new, higher loan amount because otherwise, you could lose your home if you default on the payments.

The Bottom Line

Refinancing replaces your existing mortgage with a new one, often to secure better terms. Cash-out refinancing goes a step further, letting you borrow more than your current loan balance and taking the difference in cash. This extra money can be used for major expenses or emergencies. While a cash-out refinance can give you flexibility, it also increases your debt and monthly payments, putting your home at risk if you can't repay. Make sure you weigh the pros and cons and consult a financial professional before proceeding.