Cash-out refinance: Pros, cons, when to get one

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You might have noticed that mortgage rates are near historic lows. Typically, when mortgage interest rates are low, borrowers refinance to lower their monthly payments. If you want to borrow more against your home than you owe now and get a lower mortgage rate, cash-out refinancing may be right for you.

With a cash-out refinance, you withdraw the equity you’ve built up in your home as cash. You might use the money for major home improvements, paying down debt, college tuition, or other big expenses.

What is a cash-out refinance?

A cash-out refinance pays off and replaces your current mortgage with a larger mortgage. The difference between your new mortgage and old mortgage amounts goes to you as cash — minus closing costs. 

You don’t have to stick with your current lender to do a cash-out refinance. While you may want to get a quote from them, shopping around with several lenders could help you get the best deal.

How much money can you get with a cash-out refinance?

Lenders set a minimum amount of home equity borrowers must have in order to qualify for a cash-out refinance. Remember, your equity is your ownership stake in the home. It’s made up of your down payment, the principal from your monthly mortgage payments, and any increase or decrease in your home’s market value. 

Example: Let’s say you have a mortgage balance of $170,000 and your home is worth $300,000. Your home equity is the difference between these two numbers: $130,000. Calculated as a percentage, your home equity is about 43%.

Lenders don’t allow borrowers to cash out 100% of the home’s value, so you won’t be able to get a new mortgage for $300,000. Instead, lenders usually allow homeowners to borrow 80% of the home’s value. That means you could get a new mortgage for $240,000. Your equity would then be 20% of the home’s value, or $60,000.

After subtracting your original mortgage balance of $170,000 and closing costs of $10,000, a cash-out refinance would give you $60,000.

Credible makes it easy to compare refinance rates from multiple lenders.

Cash-out refinancing requirements

Lenders set their own requirements that borrowers must meet to qualify for a cash-out refinance. Here’s what they’re generally looking for:

• A credit score of at least 620
• A debt-to-income ratio (DTI) no higher than 50%
• Enough home equity to still have 10% to 30% after cashing out

Cash-out refinancing costs

A cash-out refinance has closing costs just like a purchase mortgage or a standard refinance. Typically, your closing costs will be 2% to 5% of the loan amount. These costs include mortgage origination fees, title insurance, a home appraisal, loan closing services, and more.

Example: You want to borrow $240,000 for a cash-out refinance. Expect to pay between $4,800 and $12,000 for closing costs.

A common way to pay closing costs with a cash-out refinance is to subtract them from your loan proceeds. Adding closing costs to your loan is a common practice with a purchase mortgage or traditional refinance, and you can do it with a cash-out refinance, too. You’ll end up paying more interest over time because you’ll have to borrow more principal. 

Example: You need $110,000 for a home addition. If you borrow $240,000 to pay off a $130,000 mortgage and need to pay $6,000 for closing costs, you’ll end up $6,000 short. You’ll need to reduce your remodeling budget by $6,000, or borrow $246,000 instead.

Remember, there’s an upper limit to how much you can borrow with a cash-out refinance because the lender will require you to keep a certain amount of equity in your home: around 20%, on average. Your rate may be lower if you retain more equity.

Pros and cons of a cash-out refinance

Like any financial move, a cash-out mortgage refinance has benefits and disadvantages. The main benefits of a cash-out refinance are being able to borrow a large sum at a low interest rate and use the money for any purpose. In some cases, you’ll get a tax deduction for the interest.

However, there are drawbacks as well, including foreclosure risk, closing costs, possible PMI, and the time it takes to get the money.

Pros

First, consider these potential benefits.

Low interest rates: If it's been a while since you took out your home loan, there's a good chance you can cash in on higher home values and lower mortgage rates. You may be able to borrow more money while securing a lower rate on your new home loan — and end up with a payment similar to the one you’re making now.

Pay down other debts: A cash-out mortgage refinance can help you pay down higher-interest debts besides your current mortgage. But be cautious when doing this because this "pro" contains a hidden "con." Paying off unsecured debt, such as credit cards, with money from a cash-out refinance turns unsecured debt into debt that’s secured by your home. So weigh the risk against the benefits before using home equity to pay off unsecured debts. 

Possible tax deductions: Your proceeds from a cash-out refinance aren’t income. The IRS views the money as a loan, which means you may be able to deduct the interest from your new mortgage on your taxes if you put the money toward an improvement that increases your home’s value. However, your itemized deductions must be higher than the standard deduction to benefit from the mortgage interest tax deduction. Most people take the standard deduction.

You can compare mortgage refinance rates through Credible, which is always free to use.

Cons

The possible benefits of a cash-out refinance are important, but you need to make sure they outweigh the potential drawbacks.

Closing costs: Closing costs are one of the biggest disadvantages of any mortgage refinance. If the closing costs are too high, you may not see enough financial benefit for the loan to be worth it. All the services you pay closing costs for also take time to execute, which means refinancing can take 30 to 60 days — not good if you need money fast.

Potential PMI: Lenders may not allow you to borrow more than 80% of your home’s value with a cash-out refi. However, if they do, you might have to pay an additional expense: private mortgage insurance (PMI). In most cases, when you have less than a 20% stake in a home, lenders will require you to carry PMI, which protects the lender if you default on the loan.

Using your home like a bank: If you want to eventually own your home free and clear, a cash-out refinance will set you back. The trade-off may be worth it to you, and borrowing against a large asset at a low interest rate can be a smart way to accomplish other goals. Just don’t forget that you’re at risk of losing your home if you can’t repay your mortgage debt. Be careful about using your home equity to inflate your lifestyle.

Should you get a cash-out refinance?

A cash-out refinance may be right for you if:

• Your home needs a lot of maintenance to protect its value or your comfort and safety. Examples might include a new roof and gutters, new plumbing, or a new heating and cooling system.
• A major renovation could adapt your home to changing needs with less expense or disruption than moving. Examples might include modifications for aging in place, an extra bedroom for a child, or an accessory dwelling unit for a relative.
• You’re turning over a new leaf. If you use the cash to pay off credit cards and other high-interest debts — and don’t accumulate new high-interest debt — you may be able to save money and get a fresh start on stronger financial footing.

Alternatives to cash-out refinancing

Besides a cash-out refinance, you may have other options to pay for large expenses, many of which involve tapping home equity — but in different ways.

Home equity loan

A home equity loan also lets you cash out a significant amount of your home’s value in a lump sum. However, it allows you to keep your existing home loan. It can be a good option when you already have a great mortgage rate.

Home equity loan line of credit (HELOC)

A HELOC lets you access your home’s equity as needed instead of borrowing a lump sum. It’s another good alternative to a cash-out refi when you already like your mortgage rate. Closing costs on HELOCs and home equity loans are often lower than other loans, too. With a HELOC’s variable interest rate, however, your monthly payments will be less predictable.

Reverse mortgage

A reverse mortgage is only an option if you’re at least 62 years old and have no mortgage or a small balance. It’s best for people who want to age in place and whose largest asset is their home. It’s more expensive than cash-out refinancing and the proceeds may be substantially lower.

Personal loan

With excellent credit, a personal loan can have an interest rate similar to a mortgage or home equity loan. Closing costs are often minimal, and you won’t have to use your home (or anything) as collateral. However, a shorter repayment term can mean substantially larger monthly payments compared to a home loan.

Credible can show you rates and offers from multiple personal loan lenders.