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What Is a Cash-Out Refinance and How Does It Work?

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Kitchen with blue cabinets renovated after a cash-out refinance.

Homeownership comes with some big perks, including the option to get a cash-out refinance. Cash-out refinancing lets you tap into the value of your home to access money for home improvements, debt consolidation, or college.

It’s not free cash — you do have to repay it — but the money is repaid over a longer period and at a lower interest rate than it would be with most credit cards or personal loans. That means cash-out refinancing can be a practical way for homeowners to make large expenses more affordable.

Learn more about cash-out refinancing in this guide:

What Is a Cash-Out Refinance?

Most homes increase in value over time — that’s one of the major advantages of owning a home. Plus, monthly payments reduce the mortgage loan principal bit by bit. That eventually puts most homeowners in a position where their mortgage balance is far less than what the home is worth.

The difference between what you owe on a home and the property’s market value is called equity. Most homeowners have built thousands of dollars in equity if they’ve owned a home for at least several years.

A cash-out refinance is a loan that allows you to borrow against your home’s equity. To do so, you take out a new mortgage based on the increased market value of your home. You use the bulk of that money to pay off your old mortgage — and pocket the difference, says Kevin Leibowitz, owner of Grayton Mortgage, which has offices in Brooklyn, New York; and Cary, North Carolina.

For example, if you owe $180,000 on your mortgage and your home is worth $250,000, you could refinance at $200,000 and take the $20,000 difference in cash.

The tradeoff: You now must repay a new, larger mortgage, and you’ll likely have a bigger monthly payment. It also means you start over your loan term — typically 15 or 30 years.

That trade can be worth making if you eliminate high-interest debt that eats up your monthly budget or invest the cash in assets that typically appreciate, like renovations that increase the value of your home or a college education that helps you or your children land a higher-paying job.

Types of cash-out refinancing

Getting approved for a cash-out refi — and figuring out how much cash you can take out — depends on a few factors. A big one is the type of mortgage you have.

Common mortgage types eligible for cash-out refinancing include:

  • Conventional loans: Most mortgages are conventional loans. To refinance a conventional mortgage, you’ll need equity in the property equal to at least 20% of the home’s market value, a credit score of at least 620, and to have owned the home for at least six months.
  • FHA loans: To refinance a mortgage insured by the Federal Housing Administration, you must have owned the home and lived in it as your primary residence for at least a year. You need to have at least 20% equity and proof that you’ve made payments on time over the past 12 months.
  • VA loans: You can refinance up to 100% of your home’s value with a loan backed by the Department of Veterans Affairs. You will need to pay closing costs and the VA funding fee, which is either 2.3% or 3.6% of the loan amount, depending on the specifics of your situation.

Keep in mind that individual lenders may have additional requirements for a cash-out refinance.

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How Does a Cash-Out Refinance Work?

Cash-out refinancing uses the funds from your new mortgage to pay off the old one, essentially replacing your previous home loan. The interest rate and loan terms may be different with this new loan.

“The interest rate depends on the borrower’s credit, the value of the house, the type of mortgage, and more,” Leibowitz says.

Typically, cash-out refinance rates are slightly higher than interest rates for a regular mortgage because you’re increasing the loan size and decreasing your equity. You can use a refinance calculator to see how much your loan would cost based on the rate offered.

How much cash can you get from refinancing?

Even if you’ve built a lot of equity in your home, it doesn’t necessarily mean you can borrow against the entire amount.

“The type of mortgage (conventional, FHA, VA) will dictate what percentage of the equity can be taken out,” says James Polinori, chief marketing officer at Geneva Financial, a mortgage lender based in Chandler, Arizona.

Though there are other factors that affect how much equity you can tap into, a good rule of thumb is that a homeowner can refinance up to 80% of their home’s value, Polinori says.

An example of cash-out refinancing

Say you purchase a piece of real estate for $230,000. You put down 10%, which totals $23,000, and finance the remaining $207,000 using a 30-year fixed-rate mortgage with a 4% interest rate. After roughly 6 1/2 years, you will have paid the balance down to about $180,000. The home has increased in value to $250,000, so you have $70,000 in equity.

At the same time, you’ve racked up about $20,000 in credit card debt at an annual percentage rate of 15%, so you’re thinking about getting a cash-out refinance. Refinancing 80% of your home’s value would give you a new $200,000 mortgage. That’s enough to pay off the previous $180,000 loan and use the remaining $20,000 to cover your credit card debt.

Consolidating your debts means you would no longer make separate credit card and mortgage payments. Repaying your original credit card debt at the lower interest rate on your new mortgage also means your total monthly debt payment would shrink — saving you a lot of money. On the downside, you would be restarting your loan term, which keeps you in debt longer, and you would have to pay closing costs again on the refinance.

Closing costs for a cash-out mortgage refinance

Just like any traditional mortgage, cash-out refinancing comes with closing costs. These are fees that cover the administrative costs behind the loan and other third-party services, due when a loan closes.

Closing costs typically run 2% to 5% of the loan amount, according to Freddie Mac. So, using our $200,000 loan example, you would pay $4,000 to $10,000 in closing costs for a cash-out refinance.

“This is something that should not be overlooked when factoring in whether a cash-out refinance makes sense in the long run,” Polinori says.

Cash-out refinancing and your taxes

You might be wondering if the cash you take out by refinancing is taxable. A cash-out mortgage refinance is considered a loan, so you don’t have to pay income tax on it.

However, cash-out refinancing can affect your taxes in other ways. If you use the funds to make permanent home improvements that increase your property’s value, you can deduct the original loan interest. And if you purchased mortgage points to lower the interest rate on your cash-out refinance, you also can deduct those costs.

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What You Can Do With a Cash-Out Refinance

The money you take out can be used for anything you want, Leibowitz says.

“But I always encourage my borrowers to use it for sensible items,” he says. “Buying a car or taking a vacation and paying it off for 30 years is not a good idea.”

Below are a few common reasons why homeowners get a cash-out refinance.

Fund home improvement projects

One of the more popular reasons for a cash-out refinance is to borrow money for home improvements. Cash-out refinancing can give you the money needed to make renovations that boost the value of your home right away, without relying on high-interest credit cards or burning through your savings.

Consolidate high-interest debts

If you have credit cards or loans with high interest rates, a lot of your monthly income gets eaten up by interest charges. Cash-out refinancing allows you to consolidate debt into your mortgage and pay it off at a lower rate over a longer period.

“By paying off higher-interest accounts, you will pay much less in interest over time,” Polinori says. “By paying off credit cards and other debt, this may improve your overall credit.”

Pay for college tuition and expenses

Whether you’re paying for your own degree or putting a child through college, cash-out refinancing can be a good alternative to student loans. That’s especially true if you need to take out private student loans, which usually cost more than federal student loans.

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How To Get a Cash-Out Refinance

If you’re thinking about getting a cash-out refinance, there are a few steps to take.

1. Pass the requirements

You must meet several requirements in these areas to be approved:

  • Credit score: The minimum score required for a cash-out refinance varies by loan type and lender, but it generally ranges from 600 to 640.
  • Debt-to-income ratio: Your DTI measures how much of your monthly income goes to debt payments. The maximum DTI allowed is 50% for conventional loans, but lenders may require a lower DTI to approve your application.
  • Equity in your home: Cash-out refinancing is only possible if you have equity, and it must be at least 20% of your home’s value. Your home likely needs to be appraised to determine its current market value.

This isn’t an exhaustive list, so check with potential lenders to learn their exact requirements for a cash-out refinance.

2. Decide how much cash you need

With a cash-out refinance, it’s a good idea to take out only as much as you need to accomplish your goal. If you’re planning home improvements, itemize the work you plan to do and estimate how much it will cost. If you’re consolidating debt, add up your balances to find out how much you need to pay them off. Even if you’re allowed to borrow more, it’s important to minimize the cash you’re taking out because you’ll be paying interest on those funds for a long time.

3. Get approved by your lender

After you’ve compared several quotes and decided on a lender, gather your documentation ahead of time so the approval process goes smoothly. Have paperwork ready to verify your creditworthiness, employment history, and ability to afford the payments.

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Pros of Cash-Out Refinancing

When done right, there are many benefits to cash-out refinancing:

  • You can score a lower interest rate on your mortgage. If your credit has improved since you took out your original mortgage, or interest rates have dropped, you can simultaneously tap into your equity and refinance at a lower interest rate.
  • Renovating or repairing your home may add value. Making certain upgrades to your home, like remodeling a bathroom, could boost your property’s value.
  • You can simplify debts. Consolidating your debt with a cash-out refinance can help you save money and reduce the number of payments and due dates you have to keep track of each month.
  • Refinancing can help cover education costs. If you don’t want to take on the higher interest rates attached to private student loans, a cash-out refinance can be a cheaper option to fund education costs.

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Cons of Cash-Out Refinancing

Cash-out refinancing isn’t right for all situations. Here are a few instances when homeowners might want to consider a different option:

  • Your existing mortgage rate may increase. Refinancing doesn’t always result in a lower interest rate, especially since rates for cash-out refinances tend to be higher.
  • Your repayment term may be extended. If you refinance to a mortgage with the same term as your previous loan, you’ll restart the clock and end up paying for your home over a longer period — thus spending more on interest. Requesting a custom term could help you avoid that scenario, but choosing a shorter term will increase your monthly payment.
  • You risk losing your home if you can’t repay the loan. Since the property is collateral for your refinance, failing to make your mortgage payments means you could lose your home to foreclosure.

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Alternatives to Cash-Out Refinancing

There are other ways to borrow against your home’s equity. Here are a few alternatives.

Home equity line of credit

A home equity line of credit, or HELOC, is a type of revolving debt. Your property serves as collateral for the HELOC, and you can borrow against the home’s equity and pay it down — similar to a credit card.

HELOCs may come with a draw period that lasts a fixed amount of time, during which you can borrow against your line of credit. Once the draw period is over, you can no longer borrow money and must renew your credit line or repay the outstanding balance.

Home equity loan

A home equity loan allows you to tap your home’s equity by borrowing a lump sum that you repay in fixed, monthly payments — like your mortgage. Your property serves as collateral for your home equity loan, so it’s important to make payments on time and avoid defaulting. Otherwise, you could lose your home to foreclosure.

Reverse mortgage

Reverse mortgages are available only to people 62 and over, and allow older people to borrow against the equity in their homes as long as they live there. Rather than making a monthly mortgage payment, the homeowner receives payments from the lender as an advance on their home’s equity. The lender typically charges closing costs and other fees, and the interest on the loan grows as the borrower continues to receive payments from the reverse mortgage.

The reverse mortgage typically doesn’t have to be repaid until the borrower dies or moves out of the home. Often, the loan is repaid by selling the home. The longer a reverse mortgage is in effect, the more equity is used up by the time the loan needs to be repaid.

Reverse mortgages are complicated products that come with risks and responsibilities that should be fully understood before taking out this type of loan.

Personal loan

If you need to borrow money but don’t want to risk your home, a personal loan is another option.

“A personal loan does not tap into the existing home equity of your home, or have anything to do with your mortgage,” Polinori says.

Personal loans allow you to borrow money for almost any purpose. Some personal loans are secured, meaning they are backed by collateral and may come with a lower interest rate. It’s also possible to get an unsecured loan, but since not having collateral is riskier for the lender, interest rates on unsecured loans tend to be higher.

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Cash-Out Refinancing FAQ

Below are the answers to some common questions about cash-out refinancing.

How quickly do I get the money in a cash-out refinance?

Once you apply for a cash-out refinance, it can take anywhere from 30 to 45 days for the loan to close. Depending on your situation and the overall demand for mortgages, however, that time frame could change.

Does a cash-out refinance affect my credit score?

Any time you borrow money, there’s an effect on your credit — both positive and negative. Cash-out refinancing is no different.

When you apply for the loan, the lender performs a hard inquiry, which can temporarily ding your credit score by a few points. Taking on a new loan also means your total debt will increase, which could cause your credit score to drop slightly. However, as you repay the loan, that positive payment history will help improve your credit. And having a loan of this type in good standing helps diversify your credit mix — another positive.

When is cash-out refinancing a good idea?

Cash-out refinancing is not something you do on a whim, because it puts your home at risk if you can’t afford your payments. That said, it can be a good idea if you can use the money to improve your financial situation. For example, if you make improvements to your home that ultimately increase its value, or pay off high-interest credit card debt, cash-out refinancing can be worth it.

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The Bottom Line on Cash-Out Refinancing

Cash-out refinancing can be a lower-cost way to get money quickly. If used the right way, it can help increase your net worth over time. Whether you want to upgrade your home, consolidate debt, or pay for college, tapping into your home’s equity can be a smart move. But remember, there’s a lot at stake: Your home serves as collateral, so it’s crucial that you keep up with payments. Like with any major financial decision, it’s important to crunch the numbers and weigh the pros and cons before making your final choice.

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