What is 'Cash-Out Refinance'
A cash-out refinance is a mortgage refinancing option where the new mortgage is for a larger amount than the existing loan to convert home equity into cash.
BREAKING DOWN 'Cash-Out Refinance'
In the real estate world, refinancing is the process of replacing an existing mortgage with a new one that typically extends to the borrower more favorable terms. 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 additional borrowers from the loan obligation, or access cash through home equity built up over time.
Rate and Term Versus Cash-Out Refinancing
The most basic option in mortgage loan refinancing is the rate and term refinance. With this option, the borrower is attempting to attain a lower interest rate and/or adjust the term of the loan. If a property was purchased years ago, the borrower might find it advantageous to refinance in order to get today's prevailing lower interest rates. Also, variables may have changed in a borrower's life where a 15-year mortgage may better suit their needs in comparison to their current 30-year mortgage.
A cash-out refinance allows the borrower to convert home equity into cash by creating a new mortgage for a larger amount than the original. The borrower receives the difference of the two loans in cash. This is possible because the borrower only owes the original mortgage amount to the lending institution. The additional loan amount of the cash-out refinanced mortgage is paid to the borrower in cash at the closing.
Example of a Cash-Out Refinance
Here is an illustration of a cash-out refinance. An owner has a property which has a $200,000 mortgage against it and he/she still owes $100,000 on the mortgage. The owner has built up $100,000 in home equity. So that the owner could convert a portion of that equity into cash, they could opt for a cash-out refinance. If they wanted to convert $50,000 of their equity, they could refinance taking out a new loan worth 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.
There are 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 above 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. After the initial mortgage is paid off ($100,000), there would be $100,000 in cash available to the borrower.