A Guide to Cash-Out Refinancing

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Sometimes you need a little extra money to help with life’s big expenses, such as college tuition, home improvements or medical debt. A cash-out refinance on your mortgage allows you to leverage the equity in your home to get the cash you need. Keep reading to learn more about what cash-out refinancing is, how it works and how to make this process work for you.

How a cash-out refinance works

Normally, when you refinance your mortgage, you take out a new loan on your home with the intent of using it to pay off your existing loan. Doing so allows you to secure a better interest rate, adjust the length of your mortgage or consolidate debt if you have multiple liens on the property.

A cash-out refinance works in much the same way, except you take out a loan for more than the amount you owe on your mortgage. In this case, you use some of the equity you have built up in your home to get a cash advance. You can then use that cash to pay for your expenses and pay back the larger mortgage over time.

For example, let’s say you owe $100,000 on your $200,000 mortgage. With a cash-out refinance, you could potentially take out a new mortgage worth $150,000 — $100,000 would go toward paying off your old loan, and you’d have $50,000 for other expenses.

What are the requirements?

You’ll need to show documents when you apply for a cash-out refinance. The documents are similar to those you provided for your mortgage application, according to Adam Smith, president of the Colorado Real Estate Finance Group in Greenwood Village, Colo. They may include a W2, tax return, pay stubs, bank statements and statements from any assets or debts.

However, some requirements will be different from the first time around. In addition to documentation, a lender will look at the following for a cash-out refinance.

Credit score

The necessary credit score for a cash-out refinance loan is a bit higher than it is for a traditional mortgage. While lenders typically look for a credit score of 620 for a conventional mortgage, a score of 660 or above is required for a cash-out refinance.

Debt-to-income ratio

Your debt-to-income ratio (DTI) is the measure of your total monthly recurring debt divided by your total monthly income. Lenders look at this before approving you for a loan because it’s an indicator of how easily you’ll be able to manage repayment. In this case, you want your ratio to be less than or equal to 36%.

Loan-to-value ratio

Your loan-to-value ratio (LTV) is the comparison of your loan amount to the appraised value of your home.

“After the recession, most lenders started putting caps on the percentage of loan-to-value that you could borrow on a cash-out refinance,” Smith said. “Making sure that you still have some equity in your home protects you from owing too much and makes the investment safer for you and the lender.”

For the most part, your LTV cannot exceed 80% if you want to qualify for a cash-out refinance. However, this guideline may be specific to your loan program. FHA loans, for example, have an LTV limit of 85%, while loans backed by the VA have no LTV requirement.

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What purposes can a cash-out refinance serve?

With a cash-out refinance, Smith said, “you can do essentially whatever you want. “The equity in your home is a savings account — that’s yours.” You can use it to pay off other debts, pay for your child’s college or make home improvements, for example.

However, Smith cautioned that states may have different rules and regulations for how the money from a cash-out refinance can be used. “In Colorado and some other states, you have to justify why this money is so important to you that you need to refinance,” he said. Smith recommended checking with your loan officer to see if any limitations apply to you.

Standard vs. limited cash-out refinance

Typically, the money that you receive from a cash-out refinance can be used for just about any purchase. This is what’s known as a standard cash-out refinance. However, some loan programs (like the VA’s cash-out option) put limits on what the funds can be used toward. As the name suggests, this is what’s known as a limited cash-out refinance.

According to the Fannie Mae guidelines, limited cash-out refinancing can be used for the following:

  • Modifying the terms and interest rate on an existing mortgage
  • Paying off the balance of an existing mortgage (including prepayment penalties)
  • Paying off construction costs to build a home
  • Paying for closing costs
  • Buying out a co-owner
  • Paying off a subordinate mortgage lien
  • Paying off the balance on Property Assessed Clean Energy (PACE) loans or other debts used for energy-efficient improvements.

You can also get a small amount of cash back from a limited cash-out refinance loan, but it cannot exceed 2% of the new loan value nor $2,000, whichever is more.

Risks of a cash-out refinance

Home improvements are considered a good use of a cash-out refinance because they increase the value of the home. Paying off high-interest debt could be another smart use of a cash-out refinance.

However, doing a cash-out refinance for more frivolous purchases is risky. “If you go back 10 to 15 years ago, people were treating their homes like cash registers and taking money out to go on vacation and buy jet skis,” said Jim Sahnger, a loan officer with C2 Financial Corporation in Florida. The danger is that you borrow for luxury goods or “wants” versus “needs,” and end up with debt you can’t pay off.

Smith advised thinking about how your monthly payment will change after a cash-out refinance.
“There’s a good chance that your payment may be much higher than it was before,” he said. ”Before you take the money out, be sure that you’re able to make sense of what this change will look like in your current budget.”

Smith also warned that there’s a small chance you could end up underwater on your loan.
“There have been a lot of stops put in place since the last recession to make sure that doesn’t happen,” he said. “However, if the value of your home drops dramatically, you could end up having borrowed more than your house is worth.”

Alternatives to a cash-out refinance

If you’ve read the above and don’t think cash-out refinancing is the right fit for you, you may want to consider some of the following loan options:

Home equity loan (HEL)

Often, a home equity loan is referred to as a second mortgage because, like most first mortgages, this type of loan disburses the money to you in a lump sum and comes with a fixed interest rate. It uses the equity in your home as collateral, which is paid back over time, using fixed monthly payments.

Home equity line of credit (HELOC)

A home equity line of credit functions more like a credit card. Initially after taking out the loan, you enter what’s known as the “draw period.” During that time, typically 10 years, you’re given either checks or a credit card to draw upon the equity of your home as you wish. As with a credit card, you can borrow, pay back and borrow again against the line of credit.

You only have to worry about paying back interest during the draw period. After it ends, you then have to start paying back the loan principal at an adjustable interest rate.

Personal loan

Personal loans are different from HELs and HELOCS in that they are unsecured, meaning that they don’t use anything as collateral. This makes them much more of a risk for the lender, which is why they often come with stricter qualifying requirements and higher interest rates.

Cash-out government loan options

If you’re thinking of doing a cash-out refinance, there are government-backed options at your disposal. These loans are insured by federal agencies, which makes them less of a risk for the lender. As a result, they often have more lenient qualifying requirements and better terms than your standard cash-out refinance. Here are your options:

Federal Housing Administration (FHA) cash-out refinance

Requirements: You must have a minimum credit score of 600 and a debt-to-income ratio of less than 43%. You must also be able to show that you’ve made all the payments on your current mortgage for the last 12 months or however long you’ve owned the property if it’s less than 12 months.

Max loan limits: For FHA cash-out refinance loans, there is a limit of 85% LTV, which means that you can borrow up to 85% of the home’s current value.

Approval guidelines: To be eligible to refinance, you must have at least 15% equity in your property, according to a current appraisal.

Veterans Administration (VA) cash-out refinance

Requirements: You must have sufficient income and credit history, as well as be able to obtain a certificate of eligibility from the VA. The property must also be used as the primary residence for an eligible veteran or service member. The funds must be used for cash at closing, to pay off debt, to make home improvements or to pay off liens.

Max loan limits: There are no max loan limits on VA cash-out refinance loans.

Approval guidelines: In order to be approved for a certificate of eligibility, the veteran or service member must have been discharged under conditions other than dishonorable. They must also meet length of service requirements for their division of service.

Conclusion

If you’ve already been thinking about refinancing your mortgage and you need some extra funds, doing a cash-out refinance on your home may be a viable option. This allows you to take out more money than you currently owe on your mortgage and use the surplus to cover your expenses.

However, doing so will likely increase your monthly mortgage payment, so it’s best to only use this option to cover costs that are truly important. Talk to your financial advisor to see if cash-out refinancing is the right move for you.

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Tara Mastroeni
Tara Mastroeni |

Tara Mastroeni is a writer at MagnifyMoney. You can email Tara here

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