Beginner's guide to cash-out refinance

Cash-out refinances allow you to use the equity in your home to get the cash you need for things like home improvements, medical bills, paying for college and other large expenses. Your home is probably the biggest investment you've made in your life, and it may be a source of financing when you need it.

What is a cash-out refinance?

A cash-out refinance allows a homeowner to use the equity in their home to get funds. A cash-out refinance replaces your existing mortgage, and there are no restrictions on how you use the money.

How does a cash-out refinance work?

A traditional rate and term refinance replaces your existing mortgage with updated terms, such as lower monthly payments or a longer payment schedule. With a cash-out refinance, the purpose is to make cash available with a new mortgage. You take out more than you owe on your current mortgage, and the balance is dispersed to you to use as you need.

How to use a cash-out refinance

You can use a cash-out refinance for anything. Here are some common uses:

Home improvements

Improving your home can be expensive. Cash-out refinances can provide funding for renovations or remodeling projects using the equity in your home. Home improvements may also increase the value of your home, making it a worthwhile investment.

Debt consolidation

Other types of debt can carry higher interest rates than mortgages. Paying off high-interest credit card debt, car loan or student loans is one way to use a cash-out refinance. You can pay off higher debt sooner to avoid accumulating additional interest each month.

Large purchases

Paying for things like college tuition or a wedding can be difficult. With a cash-out refinance, you may be able to cover some of these expenses at a lower interest rate than you would with personal loans or credit cards.

How to qualify for a cash-out refinance

A cash-out refinance carries many of the same requirements as a conventional mortgage or traditional refinance. Lenders differ, but the common eligibility requirements for a cash-out refinance include:

Good credit score

A healthy credit score shows you’re able to make all your mortgage payments. Just like when you applied for your initial mortgage, a cash-out refinance requires a minimum credit score. Exact credit scores vary among lenders and change based on economic conditions. It’s also a good idea to check your credit report for any issues that may cause concerns.

Low debt-to-income ratio

Your debt-to-income ratio (DTI) is your monthly debt divided by your monthly income. Lenders use your DTI to determine whether you can reasonably take on additional debt. The lower your DTI, the better chance you have of qualifying for a cash-out refinance. Lender requirements vary, but you should aim to have a DTI of 40% or lower. 

Loan-to-value ratio

Lenders also use your loan-to-value ratio (LTV) to evaluate your eligibility for a cash-out refinance. Your LTV is the comparison of your mortgage amount to the value of your home. Some lenders won’t allow homeowners to exceed an 80% LTV to secure a cash-out refinance. 

Minimum home equity

You need equity in your home before you can secure a cash-out refinance. Equity is the difference between your home's appraised value and how much money you still owe on your mortgage. Homeowners gain equity in one of two ways:

• Paying the principal on your mortgage.
• The value of your home increases.

Lenders want to protect homeowners from owing too much, so many limit the amount you can borrow on a cash-out refinance. A cash-out refinance may require a minimum of 20% home equity, which means you can only refinance up to 80% of the value of your home. VA loans are the exception to the rule. The Veterans Administration allows eligible veterans to refinance up to 100% of the value of their homes.

Advantages of a cash-out refinance

Homeowners can enjoy many benefits with a cash-out refinance, including:

• Better rates. If interest rates drop or your financial situation has improved, you could qualify for better rates and terms with a cash-out refinance.
• Lower monthly output. Homeowners who use a cash-out refinance for debt consolidation can end up lowering their overall monthly payments. And lower interest rates and a better financial situation may lead to a lower mortgage payment, relieving some financial pressure.
• More cash-on-hand. Cash-out refinances provide the cash you need for whatever you need. Maybe you want to save for college or retirement, do home renovations or buy that big-ticket item you've been thinking about. 

Disadvantages of cash-out refinances

Cash-out refinances do come with some potential disadvantages. They include:

• Too much debt. Sometimes life circumstances work against homeowners after a cash-out refinance. You risk accumulating debt you can’t afford in the future as well as put your home at risk.
• Higher payment. It's possible your cash-out refinance results in higher payments than your previous mortgage. You need to make sure the terms of the loan align with your budget.
• Going upside-down. One disadvantage with cash-out refinances is the possibility you might owe more than what your home is worth if the value decreases. Many protections exist to help prevent homeowners from owing more than their home is worth, but there is no guarantee.

Is a cash-out refinance a good idea?

Cash-out refinances use the equity in your home to help fund the things you can’t. By replacing your mortgage with a new one, you get a portion of your home’s equity back in cash. You can choose to spend your funds any way you like, but it’s important to always understand what you can and can’t afford and keep your future financial health in mind. Contact a Home Lending Advisor to find out whether a cash-out refinance is right for you and how to get things started.