Cash-Out Refinance: How Does It Work?

Sometimes, your financial situation changes, or your current mortgage arrangement no longer works for your needs. When that happens, you may consider asking your lender for a cash-out refinance.

Borrowers often use cash-out refinance loans to consolidate debt and complete necessary home repairs. Compared to other options, like a home equity loan or home equity line of credit (HELOC), a cash-out refinance results in one lien on the property instead of two.

But what exactly is a cash-out refinance, and how does it work? Read on to learn.

What Is a Cash-Out Refinance?

A cash-out refinance, put simply, is a type of refinanced mortgage that allows you to draw from your home equity in exchange for a larger loan balance. When you refinance your loan, you start over with a new mortgage that has different terms — like a different interest rate or longer loan lifespan.

In a cash-out refinance, you take out a new loan that’s higher than your original mortgage. The difference between the new loan balance and your old loan balance is the “cash-out” part of the agreement. You pocket the cash and use it for whatever you like.

The amount of money you get from a cash-out refinance depends on your home equity and debt to income. Home equity is the total percentage of the property you have paid off from the original mortgage.

How Much Money Do You Get From a Cash-Out Refinance?

To perform a cash-out refinance, lenders usually require you to have at least 20% equity in your home. However, this can vary depending on your lender or the type of loan. For instance, with a mortgage loan from the Department of Veterans Affairs, you could potentially borrow 100% of your home's equity through a VA cash-out refinance.

Generally speaking, you can borrow up to 80% of your home’s value with a cash-out refinance. To determine your equity, take into consideration that the new loan balance will not only include the requested cash-out but also the original loan balance and closing costs. This may impact the amount you are able to withdraw from the property.

What Are the Requirements for a Cash-Out Refinance?

For a lender to approve you for a cash-out refinance, you need to meet certain requirements, including:

• A debt-to-income ratio of 40% to 50% or lower. The DTI is the percentage of your net income that you put toward your current debt.
• A credit score of 620 or higher, which will also secure you a better interest rate.
• At least 20% home equity, as mentioned. Put another way, you need to have paid off at least 20% of your home’s property value.
• A specific seasoning requirement. If you have a conventional loan, you need to have owned the house for at least six months to qualify for any cash-out refinance, no matter how much equity you’ve built up.

What Are Some Cash-Out Refinance Pros?

A cash-out refinance does come with certain key benefits, such as:

• Potentially lower interest rates compared to your current mortgage loan. Although most cash-out refinance rates are higher than the rates for first mortgages.
• No need to take out a second loan or pay more than one bill at once.
• Immediate access to funds to help with major expenses like medical bills, student loans, or home renovations. You can also use it to make a down payment on another property, afford college tuition, and pay down credit card debt. Whatever your financial goals, a fixed-rate cash-out refinance may work to your benefit.
• Ability to apply the cash from the refinance toward a debt consolidation. Eligibility can be tricky because you may not qualify for a lower-rate mortgage if you already have several debts. But it’s still a possibility.

What Are Some Cash-Out Refinance Cons?

However, a cash-out refinance also brings some potential downsides:

• You could potentially increase the risk of foreclosure. Your home is used as collateral for any mortgage, so if you can’t make your new mortgage payments, you could lose your property to your mortgage lender.
• The terms of the cash-out refi may not be desirable or as good as the terms in your original loan. Your loan may have a higher interest rate, depending on the real estate market, your loan-to-value (LTV) ratio, and the amount of equity you have. In that case, you may not find it worthwhile to take out a second mortgage.
• Underwriting a cash-out refinance can take weeks or months, so this may not be the best choice if you need money as soon as possible.
• You’ll always have to pay closing costs for a cash-out refinance loan. These are 2% to 6% of the loan in most cases, and the closing costs can take a major bite out of the total money you can receive when a cash-out refinance deal closes.

Are There Alternatives to a Cash-Out Refinance?

If a cash-out refinance works for you, you’ll end up with a new mortgage with different loan terms and a higher mortgage balance. However, it’s not the only way to escape a difficult mortgage situation.

Consider co-ownership with Balance.

Co-Ownership With Balance

Balance Homes is a co-ownership solution with a mission to help American homeowners stay connected to the homes they love by offering a flexible alternative to traditional financing when life circumstances change. Our model also focuses on long-term financial health and education, helping homeowners understand their options, manage their equity, and build a plan that fits their needs.

Ready to get started? Get your free proposal today.

Sources:

Home Equity Loans and Home Equity Lines of Credit | FTC Consumer Advice

Cash-Out Refinance Loan | Department of Veterans Affairs

What are the seasoning requirements for a cash-out refinance transaction? | Fannie Mae

What is home equity and how can you use it? | Bankrate