Cash-out refinancing: What it is and how it works

Each time a homeowner makes a payment on their mortgage, they build on the equity they have in their home. Cash-out refinancing can make it possible to turn that equity into cash without selling the home.

Cash-out refinancing might be helpful in a number of situations. But the process comes with unique considerations.

Key takeaways

• With a cash-out refinance loan, borrowers take out a new mortgage that’s larger than their existing mortgage and get the difference in cash. 
• Borrowers may consider a cash-out refinance to do things like lower their interest rate or pay for a major expense.
• There might be a limit to the amount of cash a borrower can receive from a cash-out refinance.

A cash-out refinance—sometimes called a cash-out refi—is a mortgage refinancing option. It lets borrowers replace their mortgage with a new one that’s worth more than their current balance, ideally at a lower interest rate. After refinancing, borrowers typically receive the difference between their current mortgage and the new loan in a lump sum of cash. 

The amount of money a homeowner can receive from a cash-out refinance is calculated using the total amount of equity a homeowner has. Equity is a home’s value minus any outstanding liabilities. Lenders will typically ask for a home appraisal to determine the home’s current value and establish the new loan’s terms. 

Cash-out refinancing is an option with conventional, Federal Housing Administration (FHA) and Department of Veterans Affairs loans. Other mortgage programs, like those offered by the U.S. Department of Agriculture, don’t usually offer cash-out refinancing. 

With a cash-out refinance, a borrower takes out a new loan to replace their existing mortgage. The new loan is larger than the amount the borrower owes on the existing loan. The loan amount depends on a few different factors, including the home’s appraised value, the borrower’s credit score, the lender’s terms and how much the borrower wants to take out. Many lenders let homeowners borrow up to 80% of their home’s equity. 

With the new mortgage, the borrower can then pay off the original loan and get the difference as cash. 

A homeowner has a property worth $250,000 and a remaining mortgage balance of $100,000. This means they have $150,000 in home equity, assuming they have no liabilities. They want to tap into $15,000 of their equity to renovate a bathroom. 

The homeowner can apply for a $115,000 cash-out refinance to cover what they owe on their home plus the renovation costs. If they’re approved, they could choose to pay off their existing mortgage with the new loan and use the remaining $15,000 to complete their bathroom renovation. 

A cash-out refinance loan can lower a loan’s interest rate—a common reason to refinance in general. Borrowers can also consider cash-out refinancing if they have an upcoming large expense, like home renovations or improvements.

Using a cash-out refinance to cover certain expenses, especially unsecured debt like personal loans or credit cards, may not always be the best idea, according to the Federal Reserve. That’s because the consequences of defaulting on any secured debt could include you losing the collateral.  

Before choosing a cash-out refinance loan, it might be wise to check out other ways to pay for things like school expenses, medical bills and credit card debt.

The process to get a cash-out refinance loan depends on the mortgage lender. But here are a few common steps:

Cash-out refinancing qualifications can vary. But in general, borrowers need:  

• A minimum credit score of 620
• A debt-to-income ratio below 43%
• At least 20% equity in their home

Borrowers may also need to own their home for at least six months before they can pursue a cash-out refinance, no matter how much equity they have. Some types of loans—like FHA loans—may have even longer timelines.

What’s the financial need? It makes sense to gather contractors’ quotes, do research or check statements to work out a budget. And it’s a good idea to be aware of lenders’ borrowing limits.   

When it comes time to apply, it’s worth shopping around and comparing cash-out refinance rates and terms among different lenders. 

Any type of mortgage refinancing comes with pros and cons. Cash-out refinancing has its own advantages and disadvantages. 

Possible advantages of a cash-out refinance loan include: 

• Access to a cash lump sum: Cash-out refinancing can give borrowers access to a large amount of cash, sometimes at a lower interest rate than a personal loan.
• Lower interest rate: Depending on the market rate at the time, borrowers could find a lower interest rate for their mortgage. This could result in a lower monthly payment.
• Tax advantages: If the cash-out refi payment is used to make home improvements that meet IRS requirements, the mortgage interest may be tax deductible. 

Potential disadvantages of a cash-out refinance loan might include: 

• Foreclosure risks: Will the new mortgage be good debt or bad debt? If you can’t meet the terms of your new mortgage, it could lead to a home foreclosure. 
• Appraisal fees: The home normally has to undergo an appraisal during a cash-out refinance. The appraisal fee could reduce the amount of cash borrowers are able to access after refinancing. 
• Costs and fees: Borrowers may also have to pay closing costs or other fees during a cash-out refinancing. These charges could include paying origination, title insurance and other lender fees. Again, these payments could reduce a borrower’s cash payment.
• Mortgage insurance payments: If the homeowner is permitted to borrow more than 80% of their equity, they may need private mortgage insurance for their new loan.

Cash-out refinancing is a method some people use to cover a large expense, pay off debt or deal with a financial emergency. It involves tapping into a portion of their home’s equity. It’s secured debt, so the collateral can be taken if the debt isn’t repaid.

Among other things, loan approval depends on a borrower’s credit score. So if cash-out refinancing is something you might be interested in, check out how to maintain a good credit score.