Thinking about some home improvements, such as putting on an addition or remodeling a kitchen? You might want to consider a Federal Housing Administration (FHA) cash-out refinance.
The FHA cash-out refinance loan allows you to refinance your mortgage, typically at a lower interest rate, and pull out up to 80% of the equity that you have in your home for remodeling or home improvements (as well as debt consolidation and other reasons). Equity is the difference between the current value of your house and the amount that you owe on the mortgage.
- The FHA cash-out refinance works like other cash-out refinance loans. If you owe $200,000 on your mortgage, for example, then you might get a new loan for $225,000. You use $200,000 of it to pay off your previous loan, and the $25,000 balance is yours for your home improvement project.
- FHA loans are good for people with lower credit scores and are more lenient about debt ratios than other loans.
- An FHA cash-out refinance allows you to borrow money to improve your home at today’s low interest rates by using the equity built up in your house.
How Much Money Can You Cash Out?
How much money you can take in an FHA cash-out refinance will depend on how much equity you have built up in your home. But you must have at least 20% of equity left over after you refinance and take out some cash. In other words, you cannot take all of the available equity.
You can get an idea of how much your home is worth is by using websites like Zillow for an estimate. Then subtract what you owe on your mortgage from your home’s estimated value. If you owe $250,000 but your home is now worth $450,000, that leaves you with $200,000 of equity. You could take a $360,000 total loan, which is 80% of your home’s value. Of that, $250,000 will go to pay off your mortgage, and $110,000 minus closing costs would be available for your cash-out.
Who Can Qualify for an FHA Cash-Out Refinance?
According to FHA guidelines, applicants must have a minimum score of 580 to qualify. However, most lenders that provide FHA cash-out refinance loans set their limits, which typically need a minimum score in the 600–620 range. Some lenders will use the middle score if there are three different scores. Others may require that the lowest score qualifies. Your lender is the best source of information on their credit score requirements.
To make sure you can afford your new mortgage payment without getting in over your head, the FHA has guidelines on the debt-to-income (DTI) ratio that you need to qualify. This can be calculated in several different ways, but essentially, it’s how much debt you have compared to your gross monthly income. The two different methods of calculating this include:
- Mortgage payment to income is calculated by dividing your total housing payment (principal, interest, taxes, insurance, homeowners association [HOA] fees, etc.) by your gross monthly income. This number must be lower than 31%.
- Total fixed payment to income is calculated by adding up your total mortgage payment (principal, interest, taxes, insurance, HOA fees, etc.) and all of your recurring monthly expenses, such as student loans, credit card debt, auto loans, etc. Divide that amount by gross monthly income. This is your debt ratio and needs to be less than 43%.
Maximum Loan-to-Value Ratio
A loan-to-value (LTV) ratio is the amount of equity that you have built up in your home. Say you have a mortgage for $315,000, but your home is worth $500,000. The difference of $185,000 is your LTV. To qualify for an FHA cash-out refinance, the amount that you owe on your mortgage cannot be greater than 80% of your home’s value. Using the example mentioned above of your home being worth $500,000, 80% is $400,000 ($500,000 × 0.8). If you owe more than $400,000, then you wouldn’t qualify for the FHA cash-out refinance.
Time in Residence
The FHA also has a length-of-residence qualification to qualify for the cash-out refinance loan. You must live in your home and have had the mortgage that you will be refinancing for at least 12 months.
Mortgage Payment History
To qualify for the FHA cash-out refinance, you also must have an on-time payment history on your mortgage for the past year. That means you can’t have any late payments within the past 12 months.
FHA cash-out refinances typically have low interest rates. On average, they’ll be 10–15 basis points (0.10%–0.15%) lower than conventional cash-out refinance loans. However, because the FHA offers more flexibility with credit scores and debt ratios compared to conventional loans, the loan requires you to have mortgage insurance with up-front and monthly mortgage insurance premiums (1.75% of the new loan amount up front and 0.85% of the loan amount annually in 12 payments per year).
The Bottom Line
Despite the added insurance mentioned above, if you need a cash-out refinance loan and have a higher DTI ratio or lower credit scores, then the FHA cash-out refinance is a good product to examine. For those with good credit and 20% equity, a conventional cash-out refinance would be more cost-saving.
What Is an FHA Cash-out Refinance Loan?
An FHA cash-out refinance loan is a refi of an existing loan backed by the Federal Housing Administration. While FHA cash-out refi loans act just like a conventional refi loan, they must conform to certain loan-to-value and debt-to-income standards per policies and underwriting standards mandated by the FHA.
What Is a Debt-to-Income (DTI) Ratio?
A debt-to-income (DTI) ratio is simply a percentage that is calculated by dividing your total debt obligations (mortgage, car loan, personal loans, credit card amounts owed, student loans, etc.) by your gross income. The FHA requires borrowers to have a DTI ratio of 43% or less. Another method of calculation is to simply take all housing-related expenses (mortgage principal, interest, taxes, insurance) and divide by gross income. That ratio cannot exceed 31%, according to FHA standards.
What Is a Loan-to-Value (LTV) Ratio?
A loan-to-value (LTV) ratio calculation of how much of a cash-out refi loan will be made by a lender based on the equity that a borrower has in their home. FHA underwriting standards require that refi loans must conform to an LTV ratio of 80% or less of the appraised value of the home. So, if a borrower wanted to refinance a mortgage on a home worth $500,000, the maximum refi loan would be $400,000.