How does a cash-out refinance work? Everything you need to know

You might consider refinancing your home loan if you’ve had your current mortgage for a while. Refinancing your mortgage generates a new loan that pays off your existing housing debt. Most people do what’s called a rate-and-term refinance to get a better interest rate, different repayment term, or lower monthly payment. 

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However, some borrowers refinance their property to tap into their home equity – this is known as a cash-out refinance. We’ll explain everything you need to know about this financial product so you can decide if it's right for you.

What is a cash-out refinance?

A cash-out refinance is the process of securing a new, larger mortgage that pays off your current home loan and gives you a lump sum of cash after closing. You can use the money for any purpose, but many borrowers consolidate debt, make major home improvements, or cover other significant expenses.

How does a cash-out refinance work?

Getting a cash-out refinance shares many similarities with securing a standard mortgage. Here are the steps you can expect to take:

Determining your cash needs

You should have a clear reason for doing a cash-out refinance. You should also estimate how much cash you need from the transaction. For example, add the balances from your most recent billing statements if you want to pay off high-interest credit card debt.

Assessing your home's equity

Since a cash-out refinance lets you borrow against your home equity, you need to determine how much home equity you have. Home equity is the difference between the appraised value of your property and how much you owe on it. For example, if your house is worth $500,000 and your mortgage balance is $100,000, you have $400,000 worth of equity.

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Generally, you can borrow up to 80% of your home equity. If you have a VA mortgage, you may be able to borrow 100% of your equity. 

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So, if you own a home worth $500,000 and have $400,000 in equity, you can borrow up to $400,000 total ($100,000 to pay off your existing mortgage and $300,000 to spend as needed). You’ll maintain the 20% equity position (also known as the loan-to-value ratio) your lender requires.

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Key term: Loan-to-value (LTV) ratio: How much of your home’s value you borrow.

Qualifying for a cash-out refinance

Every lender will have different cash-out refinance requirements. However, here are some general rules of thumb:

• Credit score: 780+ for the best interest rates; 620+ for conventional loans; as low as 500 on Federal Housing Administration (FHA) loans
• Debt-to-income (DTI) ratio: Maximum of 40%-50%
• Home equity: 20%+
• Timeframe: You must wait at least six months since your last home loan closing on the property before doing a cash-out refinance.

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Note: Lenders typically have stricter credit score requirements for cash-out refinances than rate-and-term refinances because they take on a greater risk since there’ll be less equity in the home.

Appraisal and property valuation

Your lender will likely require a property appraisal before issuing your cash-out refinance mortgage. That way, they can be sure they don’t lend you more than the home is worth. 

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A professional appraiser will typically visit the property and assess its condition and amenities. Then, they will look for comparable home sales in your area. The appraiser will review the data, assign a value to the residence, and submit a report to your lender.

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If the house appraises for as much or more than you expected, your plans can move forward without a hitch. However, if the appraisal comes in low, you may not be able to borrow cash as much as you need.

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Returning to our cash-out refinance example, let’s say the home you thought was worth $500,000 only appraised for $400,000. You could only borrow $220,000 in equity ($320,000 total) if your lender required you to maintain a 20% equity position.

Loan application and approval

When you’re ready to apply for your new mortgage, pre-qualifying with several lenders is a smart idea. That way, you can choose the best deal for your financial situation. (Don’t worry. Pre-qualifying won’t hurt your credit because the process doesn’t result in a hard credit pull).

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Once you’ve determined which loan you want, you should submit a formal loan application. Generally, you can complete this task online. Be prepared to supply personal information and answer questions about your income, debt, assets, and overall financial standing.

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You may have to upload supporting documentation, such as your identification, pay stubs, or tax returns. At this point, the lender will do a hard pull on your credit, which could cause your score to drop by a couple of points.

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The underwriting timeline will vary by lender. However, you can generally expect to close on your approved loan within 60 days of submitting your application. 

Closing and disbursement of funds

Closing on your cash-out refinance will seem similar to closing on your initial mortgage. Be prepared to review and sign several legal documents.

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You’ll also need to pay between two and six percent of your new loan amount in closing costs. For example, if your new mortgage is $300,000 and your closing costs are four percent, you’ll need $12,000 to close.

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You can bring a cashier’s check for the balance on closing day. You could also have the expenses rolled into your loan or taken from the cash you receive.

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While your new mortgage will get finalized on closing day, you likely won’t receive your cash payout at the same time. Generally, you’ll have to wait an additional three to five days.

How does repayment work?

Your cash-out refinance loan will have a standard mortgage repayment term, like 15 or 30 years. Interest rates on a cash-out refinance are considerably lower than on a credit card. However, due to increased lender risk, your rate will likely be higher with this loan than if you got a rate-and-term refinance.

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Cash-out refinance interest rates fluctuate like other mortgage rates. Currently, rates are generally between six and seven percent. However, your rate could be higher or lower based on your creditworthiness and other factors.

The pros and cons of a cash-out refinance

There are several pros and cons of doing a cash-out refinance. Here are the most significant:

Pros

• You may be able to borrow a large sum
• Lower interest rate than a personal loan or credit card
• Lengthy repayment term (up to 30 years)

Cons

• Potential foreclosure if you default
• Long underwriting process (may take up to 60 days to close)
• Stricter credit requirements and higher interest rates than rate-and-term refinances

Cash-out refinance vs. home equity loan

When you complete a cash-out refinance, you replace your existing mortgage with a new home loan. However, when you take out a home equity loan, you walk away with a second mortgage. Your current mortgage will stay the same. Generally, a home equity loan will have a higher interest rate than a cash-out refinance because it’s a second mortgage.

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A home equity loan can make sense if mortgage interest rates have significantly increased since you purchased your property. However, since a home equity loan will likely have a higher rate than a cash-out refinance, you’ll have to do the math to see which one is your best financial bet.

Cash-out refinance vs. HELOC

A home equity line of credit (HELOC) is also considered a second mortgage. However, a HELOC functions much more like a credit card than a loan. Rather than receiving a lump sum, you’ll get access to a credit line you can use as needed during what’s called the draw period.

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During the draw period, you can spend up to your credit limit. You’ll only be responsible for repaying the amount of credit line you use. Depending on your lending agreement, you may have to make interest-only payments during this phase. Once the draw period ends, you enter full repayment. During this phase, you’ll make principal and interest payments until the debt is gone.

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A HELOC could be right for you if you like the flexibility of having a credit line vs. a set amount of funds from a cash-out refinance. However, you’ll generally need good to excellent credit to qualify for a HELOC. A cash-out refinance may fit your situation better if your credit score is mediocre.

Cash-out refinance vs. Home Equity Investment (HEI)

A Home Equity Investment (HEI) is a partnership, which makes it a little different from a traditional loan. You receive a lump sum of cash in exchange for part of your property’s future appreciation. 

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Like a mortgage, the partnership can last as long as 30 years. However, you may be able to buy back your equity or sell your home and pay your partner at any time during your agreement.

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Unlike a mortgage, an HEI doesn’t have income requirements or strict credit eligibility criteria. You also don’t have to make monthly payments.

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An HEI may work well if you want to tap into your home’s equity without taking on more debt. An HEI could also be a good solution if your financial situation makes qualifying for other home equity-related financial products difficult.

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However, HEIs aren’t available in every state. Plus, if you go with a cash-out refinance, you can keep all of your property’s appreciation when you sell it.

Final thoughts

A cash-out refinance can help you access your home’s equity. However, it’s not your only option for consolidating your debt or covering major expenses.

If you’re curious about home equity investments, see how much cash you could receive and pre-qualify today. It’s fast, free, and doesn’t obligate you in any way.