How Does a Cash-Out Refinance Work?

Written by Ashley Sutphin Posted On Wednesday, 30 August 2023 00:00

While there is some definite softening in the real estate market, the prices in most places are still sky-high. That’s leaving homeowners who aren’t ready to sell wondering how they can tap into the high home prices.

One way is to use your equity, and a cash-out refinance one specific option to do that.

When you get a cash-out to refinance, you replace your current mortgage with one new and larger. Then you’re paid in cash the difference between what you borrow and what you owe on your house.

The difference between the new amount of your mortgage and the balance on your previous mortgage goes to you at closing in the form of cash, and you can spend that on your financial needs. You do have to realize you’re going to be repaying a larger loan with different terms. With interest rates currently soaring, make sure you do your homework before you go for this option.

How Does Cash-Out Refinancing Work?

You are essentially starting over when you refinance, getting a new mortgage with different terms.

There are varying reasons people refinance. One is to get a new interest rate, although that’s probably not your goal as they are going up.

Another reason is to change your mortgage's length or add or remove a borrower. These are things that you can do without changing how much you borrow.

A straightforward refinance is different from a cash-out refinance because, in this situation, you’re getting a new loan that’s for more than what’s owed on your current mortgage.

The difference is the cash-out. How much cash you get depends on your home equity.

Home equity is what your home is worth compared to what you owe.

If your home is valued at $300,000 and your mortgage balance is $200,000, you would have $100,000 in equity. You could refinance your loan balance for $250,000, giving you $50,000 in cash at closing.

A cash-out refinance on your home equity, so a lender requires that an appraisal be done to assess your home's current value. If the home prices have gone up in your area, your property might be worth more than you paid so that it could increase your borrowing power.

A lender will want you to keep at least 20% equity in your home in most cases, but it depends on your loan and lender. If you have a loan backed by the VA, you might be able to use a VA cash-out refinance and borrow 100%.

How Do You Qualify for a Cash-Out Refinance?

To get a cash-out to refinance, you will have to meet lender requirements. As you would with any other mortgage or loan, shop around to find out which lender will give you the best terms.

You’re going to have to meet the following in nearly all cases:

  • Debt-to-income ratio: Your DTI is the monthly debt payments you’re responsible for, including your current mortgage, divided by your gross monthly income. To qualify to get a cash-out refi from most lenders, you’ll likely need no higher than 45% for your DTI.
  • Credit score: As with any loan, a higher credit score will probably get better interest rates for you, but to qualify, a score as low as 620 could work.
  • Home equity: As mentioned, you’ll need to have a minimum of 20% equity in your home to qualify for a cash-out refinance, so that means you should have paid off at least 20% of the current value of your home, based on an appraisal.
  • Seasoning requirement: When you have a conventional loan, you must have owned your home for at least six months to qualify for a cash-out refi, regardless of the amount of equity you have. There’s an exception if you inherited the property or it was legally awarded to you in some other way. A VA loan also requires a wait of six months. If the Federal Housing Administration backs your loan, you have to wait at least 12 months before you can do a cash-out refinance.

What Are the Upsides?

There are beneficial situations that can come from a cash-out refi. For example, you might have a lower interest rate depending on when you first bought your home. It’s a refinance, so you’ll have a single loan payment every month. Otherwise, if you wanted to leverage the equity in your home, it might require a second mortgage.

You’ll have access to more money, so you might be able to make a big purchase like a home renovation and generally borrow significantly more than you could with personal loans or credit cards.

What About the Downsides?

There are downsides with cash-out refinancing to weigh carefully too.

For example, there’s a foreclosure risk because your home is the collateral for any mortgage. If you can’t make the payments, you risk losing it.

You’re also going to get new terms, which can be good but also bad depending on what they are.

Finally, the process is time-consuming, and underwriting tends to take weeks. Plus you’re going to pay closing costs ranging from 2-5% of a loan.

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