What Is a Cash-Out Refinance?
A cash-out refinance is a mortgage refinancing option in which the new mortgage is for a larger amount than the existing loan in order to convert home equity into cash.
Understanding 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 additional borrowers from the loan obligation, or access cash through home equity that has built up over time.
Rate-and-Term vs. 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 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.
- A cash-out refinance means your new mortgage is for more than your previous mortgage, and you get the difference in cash.
- You usually have to 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.
A cash-out refinance has a different goal. It allows the borrower to convert home equity into cash by creating a new mortgage for a larger amount than what's 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's left on the original mortgage amount. The additional loan amount of the refinanced, cash-out mortgage is paid to the borrower in cash at the closing.
Cash-out loans generally come with higher interest rates or other costs, such as points, than rate-and-term loans. Lenders are worried that borrowers who've already taken out substantial equity might be more likely to walk out on their new loan, although a very high credit score and low loan-to-value ratio (LTV) can allay those concerns and help you get a more favorable deal.
Example of a Cash-Out Refinance
Here is an illustration of a cash-out refinance. A homeowner has a property on which they took out a $200,000 mortgage; they still owe $100,000 on the mortgage. This means that the owner has built up $100,000 in home equity. 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, 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.
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 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.