What Is a Cash-Out Refinance?

In the real estate world, refinancing is the process of replacing an existing mortgage with a new one that typically extends more favorable terms to the borrower. By refinancing, the borrower may be able to decrease their monthly mortgage payments, negotiate a lower interest rate, renegotiate the number of years—or term—of the loan, remove other borrowers from the loan obligation, or access cash through home equity that has built up over time.

A cash-out refinance is a mortgage refinancing option in which the new mortgage is for a larger amount than the existing loan amount in order to convert home equity into cash.

Key Takeaways

  • In a cash-out refinance, a new mortgage is for more than a previous mortgage balance, and the difference is paid in cash.
  • You usually pay a higher interest rate or more points on a cash-out refinance mortgage, compared to a rate-and-term refinance, in which your mortgage amount stays the same.
  •  Depending on your property’s loan-to-value ratio, the lender will set a maximum on how much cash you can take out when refinancing.

Rate-and-Term vs. Cash-Out Refinancing

The most basic mortgage loan refinance is the rate-and-term. With this type, the borrower is attempting to attain a lower interest rate and/or adjust the term of the loan. For example, if a property was purchased years ago when rates were higher, the borrower might find it advantageous to refinance in order to take advantage of lower interest rates that now exist.

Also, variables may have changed in a borrower's life so that they could now handle a 15-year mortgage (saving massively on interest payments), even though it means giving up the lower monthly payments of their current 30-year mortgage.

The cash-out refinance has a different goal. It allows borrowers to convert home equity into cash by creating a new mortgage for a larger amount than what is currently owed. The borrower receives the difference between the two loans in cash. This is possible because the borrower only owes the lending institution what is left on the original mortgage amount. The additional loan amount of the refinanced, cash-out mortgage is paid to the borrower in cash at closing.

Compared to rate-and-term, cash-out loans generally come with higher interest rates or other costs, such as points. Lenders are worried that borrowers who have already taken out substantial equity might be more likely to walk out on their new loan, though a high credit score and low loan-to-value ratio (LTV) can allay those concerns and help the borrower get a favorable deal.

Example of a Cash-Out Refinance

A homeowner took out a $200,000 mortgage to buy a property and, after many years, still owes $100,000. This means that the owner has built up at least $100,000 in home equity (assuming the property value has not dropped below $200,000). To convert a portion of that equity into cash, the owner could opt for a cash-out refinance.

If they wanted to convert $50,000 of their equity, they could refinance by taking out a new loan for a total of $150,000. The new mortgage would consist of the $100,000 remaining balance from the original loan plus the desired $50,000 that could be taken out in cash. In other words, they can assume a $150,000 new mortgage, pay back the $100,000 owed on the first mortgage and have $50,000 remaining.

The maximum amount of cash available to an owner in a cash-out refinance depends on the property's loan-to-value ratio.

Limits to Cash-Out Refinancing Options

By calculating the property's present loan-to-value ratio (LTV), a lender can establish a maximum loan amount for a cash-out refinance. The lender looks at the current market value of the property in comparison with the outstanding balance the borrower owes on the existing loan.

If we use the previous example—and assume that the current market value of the property is $250,000—and that the lender has set a maximum LTV of 80%, the maximum cash-out refinance amount would be $100,000. The 80% LTV would establish that the maximum amount of the new loan would be $200,000, or $250,000 x .80. After the initial mortgage is paid off ($100,000), there would be $100,000 in cash available to the borrower.