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 your mortgage, you may be able to decrease your 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 your previous mortgage balance, and the difference is paid to you 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, you are attempting to attain a lower interest rate and/or adjust the term of your loan. For example, if your property was purchased years ago when rates were higher, you might find it advantageous to refinance in order to take advantage of lower interest rates that now exist. In addition, variables may have changed in your life allowing you to handle a 15-year mortgage (saving massively on interest payments), even though it means giving up the lower monthly payments of your 30-year mortgage.

Cash-out refinancing has a different goal. It allows you to convert home equity into cash by creating a new mortgage for a larger amount than what is currently owed. You receive the difference between the two loans in tax-free cash (the government does not count the money as income). This is possible because you only owe the lending institution what is left on the original mortgage amount. The additional loan amount of the refinanced, cash-out mortgage is paid to you in cash at closing, which is generally 45 to 60 days from the time you apply.

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

Example of a Cash-Out Refinance

Say you took out a $200,000 mortgage to buy a property and, after many years, you still owe $100,000. This means that you have 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, you could opt for a cash-out refinance.

If you wanted to convert $50,000 of your equity, you 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, you can assume a $150,000 new mortgage, pay back the $100,000 owed on the first mortgage, and have $50,000 in cash remaining.

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.

Continuing the example—and assuming that the current market value of your property is $250,000 and that the lender has set a maximum LTV of 80%—your 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 you.

Cash-Out Refinance vs. Home Equity Loan

What’s the difference between a cash-out refinance and taking a home equity loan? Well, with a cash-out refinance, you pay off your current mortgage and enter into a new one. With a home equity loan, you are taking out a second mortgage in addition to your original one, meaning that you now have two liens on your property, which translates as having two separate creditors, each with a possible claim on your home.

Closing costs on a home equity loan are generally less than those for a cash-out refinance, so if you need a substantial sum for a specific purpose, it may be the way to go. However, if you can get a lower interest rate with a cash-out refinance—and you plan to stay in your home for the long term—the refinance probably makes more sense. In both cases, though, make sure of your ability to repay, because otherwise you could end up losing your home.