How does a cash-out refinance work?

Major purchases are often funded with personal loans, but if you have equity in your home, you have another option. You might be able to do a cash-out refinance on your mortgage to use the equity you have to fund your goals. To qualify for this loan, you usually need a credit score of at least 620 and a debt-to-income (DTI) ratio of no more than 45%. Plus, you’ll need to maintain at least 20% equity in your home, as verified by a current appraisal ordered by your lender.

If you haven’t yet built up much equity in your home, you plan to pay the funds back quickly or you want to access your equity repeatedly, a cash-out refinance might not be the right option. Instead, you may want to consider an alternative, such as a home equity loan, home equity line (HELOC) or credit or personal loan.

Key insights

• The funds from a cash-out refinance can be used for virtually any purpose.
• Cash-out refinances are a good option if you have equity in your home, a low debt-to-income ratio and a credit score of 620 or higher.
• You might consider an alternative to cash-out refinancing if you’re planning on using the funds multiple times or want to pay off the debt quickly.

What is a cash-out refinance?

With a cash-out refinance, you can take out some of your home equity in cash by replacing your existing mortgage with a new mortgage with a higher principal balance. The difference is paid out to you in cash. This type of mortgage refinance allows you to convert some of your home equity to cash without taking out a second loan on top of your original mortgage.

Rather, your existing mortgage will be paid off with proceeds from the new one. The cash you receive from the refinance can be used for nearly any purpose, including paying off high-interest-rate debt, making home improvements, funding your child’s education or achieving other financial goals.

How does a cash-out refinance work?

You’ll begin the cash-out refinance process by applying with a mortgage lender. After you’ve applied, the lender will order a new appraisal to determine the current value of your home. If you’re approved and take out a loan, your lender will use the funds from the new loan to pay off your existing mortgage and cover any closing costs. You’ll get the balance in cash.

The amount of cash you get depends on your home equity and qualifications. You’ll usually need to keep at least 20% equity in your home based on its current appraised value and meet your lender’s qualifications for DTI ratio and other factors. However, equity requirements can vary by lender and mortgage type. For example, with a VA cash-out refinance loan, you may be able to borrow up to 100% of your home’s appraised value.

Once your lender has received the appraisal, it will determine how much equity is available. Suppose your home’s appraised value is $300,000 and your existing mortgage is $200,000. To maintain 20% equity in your home, the maximum amount you can borrow is $240,000 (80% of the appraised value). This means you could take up to $40,000 of your home’s equity in cash, minus any fees or other closing costs.

You’ll most likely be required to pay for the updated appraisal and other closing costs. You may be able to roll these costs into the mortgage, but they’ll reduce the cash you receive from the refinance. Refinancing closing costs are often less than 1% of the new mortgage amount. However, closing costs on a refinance could be as high as 3% to 6%, depending on the type of loan you get, your lender and where you live. Assuming closing costs of 1%, you would pay $2,400 in closing costs on a $240,000 cash-out mortgage refinance.

Let’s take a closer look at our cash-out refinance example:

What do I need for a cash-out refinance?

To qualify for a cash-out refinance, you’ll need to have sufficient equity in your home and meet your lender's other requirements. Here are some of the standard qualifications:

With a higher credit score, you’ll have more options for a cash-out refinance. You’ll get better interest rates and can have a higher DTI ratio if your credit score is above 700.

• Home equity of at least 20%: You’ll typically need to maintain at least 20% equity in your home to qualify for a cash-out refinance, but may be able to borrow up to 100% of your home’s value with a government-backed program, like a VA loan. Your lender will determine your home’s value by obtaining a new appraisal. The amount of equity is calculated as the difference between the appraised value of your home and the mortgage amount.
• Credit score of 620 or better: To qualify for a cash-out refinance, you often need a credit score of at least 620. However, a minimum credit score may not be required, or a score as low as 580 may be allowed in some cases, such as with VA loans. Rather than relying on your credit score, these lenders will evaluate your entire credit profile to determine if you qualify.
• DTI ratio of 45% or better: The DTI ratio you need depends on your home equity, credit score and cash reserves. Maximum DTI ratios commonly range from 36% to 50%. A DTI ratio of up to 45% is often allowed if you have at least 20% home equity, a 700 credit score and two months of cash reserves. Higher DTIs of 50% may be allowed with more equity, higher cash reserves and a better credit score.
• Own your home for at least six months: Many lenders have a seasoning requirement for you to have owned your home for at least six months before applying for a cash-out refinance. Common exceptions to the seasoning requirement include situations where you got the home through an inheritance or a legal settlement, such as divorce.

When asked about what it takes to qualify for a cash-out refinance, Sean Grzebin, the head of consumer originations for Chase Home Lending, provided the following insights: “Compared to a standard rate-and-term refinance, cash-out refinances typically require a higher credit score and lower loan-to-value ratio to ensure a customer’s ability to repay the loan with higher monthly mortgage payments. Customers should work with a qualified home lending advisor to understand available options. A home lending advisor can help you understand how much you can afford and whether you qualify.”

Cash-out refinance alternatives

While a cash-out refinance can be a good way to access the equity in your home, it may not always be the best option. If your existing mortgage carries a low interest rate, you want to access the equity and repay it multiple times, you can quickly repay borrowed funds or you need fast funding, then you may want to consider an alternative. Three possible cash-out refinance alternatives are home equity loans, home equity lines of credit and personal loans.

Home equity loans

A home equity loan allows you to cash out some of the equity in your loan without refinancing your existing mortgage. Rather than paying off your mortgage with a new loan, you take out a second mortgage. Although you’ll have to make two payments, a home equity loan may be a good alternative to a cash-out mortgage refinance if your existing mortgage carries a low interest rate.

In addition, if you choose a shorter term on your home equity loan, such as 15 years versus 30 years, you’ll save even more money, since the extra amount you borrowed will be paid off in half the time.

Home equity lines of credit

A HELOC is better than a cash-out mortgage refinance if you want to access your home’s equity more than once and can pay the funds back quickly. A HELOC works similarly to a credit card because you can repeatedly borrow and repay the funds. However, you’ll pay a much lower rate than with a credit card since the HELOC is secured by your home, whereas most credit cards are unsecured.

Even though you’ll pay a lower interest rate than with a credit card, you shouldn’t get a HELOC if you don’t think you can quickly repay the funds. HELOCs carry a variable interest rate and require interest-only payments, so you’ll pay more interest in a high-rate environment. If you can’t repay or refinance the balance when the term of your HELOC expires, you risk losing your home.

Personal loans

A personal loan may be better than a cash-out refinance if you need to borrow a small amount, you need the funds quickly and you can repay the funds quickly. Personal loans sometimes start as low as $1,000, with maximums ranging from $35,000 to $100,000. You’ll usually need to repay the personal loan in two to eight years. One advantage of a personal loan is that it’s usually unsecured — meaning it doesn’t require collateral, like a mortgage.

Bottom line

A cash-out refinance allows you to convert some of your home’s equity to cash and still only have one mortgage payment. You’ll typically need to keep at least 20% equity in your home, have a DTI ratio of 45% or less and have a credit score of at least 620 to qualify. While funding typically takes about 30 to 45 days, you can use the funds for virtually any purpose. This makes it a relatively flexible financing option.

While a cash-out refinance may be a great choice if you have plenty of equity, can qualify and don’t need quick funding, it’s not the only option for accessing cash as a homeowner. Depending on your circumstances, you might also consider a home equity loan, HELOC or personal loan. Before making a decision, carefully weigh the options and seek the advice of a financial expert if you need help choosing.