Cash-Out Refinance: A Primer for Borrowers

Published on February 3, 2017

– 8 min read

A cash-out refinance, or taking out cash when you refinance, can be an intriguing way to tap the equity in your house.

But how do you know if a cash-out refinance is the right fit for your financial goals? In this post we’ll cover:

  • Cash-out refinance vs. traditional rate and term refinance
  • Cash-out refinance vs. home equity line of credit (HELOC) or home equity loan
  • Pros and cons of cash-out refinancing

Cash-Out Refinance vs. “Traditional” Refinance (Rate & Term)

When you refinance your mortgage, you’re essentially applying for an entirely new loan to replace your existing mortgage, with the goal of restructuring or changing the terms on your home loan. One common example of this is refinancing at a lower interest rate, which can save you money on interest. Another example is going from a 15- to 30-year term, which can lower your monthly payments. Or going from an ARM to Fixed.

 
In a cash-out refinance, you refinance for more than the balance of your existing mortgage. There are several types of cash-out refinance, but three common ones are:

  1. Cash-out refinance. You take the extra money in cash to do whatever you please with it.
  2. Debt consolidation refinance. Your mortgage lender uses the extra money to directly pay off your credit cards and/or other debts.
  3. Home improvement refinance . The money is distributed as a 203(k) loan to fund home improvements.

Returning to our example, this is how a straight cash-out refinance would work:
 

Say the payoff amount on your existing mortgage is $100,000 and your home is valued at $200,000. Instead of refinancing for the payoff amount, you can opt to refinance for a new loan of $125,000. Of that, $100,000 covers what you owe on the home, some of it is used to cover closing costs on the new loan, and the remaining amount is taken out in cash. The equity in your home is decreased by the amount of the $25,000 cash-out.
 

A cash-out refinance calculator can help you estimate how much equity you can pull out of your home and what the payments on the new loan might be. Wondering about your loan-to-value ratio (LTV) for refinancing? It’s also important to note that most lenders will not allow you to take out cash beyond an 80% loan-to-value ratio for refinancing.
 

Cash-out Refinance vs. HELOCs and Home Equity Loans

To fully appreciate the pros and cons of a cash-out refinance, it helps to understand some of the other common ways that homeowners tap into their equity.

 
One is a home equity line of credit (HELOC). A HELOC gives you access to a specified pool of cash, as determined by your home’s value and the outstanding balance on your first mortgage. You can typically borrow up to 90% of your home’s value with this product, and terms generally dictate a 10-year interest-only “draw” period, followed by a 15-year repayment phase. HELOCs typically come with a variable interest rate, and are most useful for borrowing small amounts of money for short periods of time.

 
Homeowners can also take out a home equity loan, commonly known as a second mortgage. Money is received in one lump sum, and rates are often fixed. Unlike a HELOC, which is revolving debt (similar to a credit card), a home equity loan is issued all at once with a specific repayment term. This reduces the temptation of continuously borrowing against your home.

 
Both home equity loans and HELOCs exist separately from your current mortgage; they do not replace it as a cash-out refinance does.

So why would you choose one of these options vs. a cash-out refinance? Every situation is different, but here’s a typical breakdown:

  1. If you expect to have ongoing cash needs (for example, to pay for multiple home renovations), a HELOC gives you access to money whenever you need it.
  2. If you need one big lump sum (for example, to pay off high interest debt), a home equity loan can cover your needs without tempting you to borrow more than you need.
  3. If you’re looking to refinance AND you want to take some of the money out of your home, a cash-out refinance could be your best bet.

In other words, it doesn’t make sense to refinance your home just to borrow money against it–the “cash-out” part is complementary to your other refinancing goals (such as lowering your interest rate or changing the loan term).

Benefits of Cash-Out Refinance

Along with the conventional benefits of refinancing—lowering your interest rate, adjusting the length of your mortgage and changing the loan terms—a cash-out refinance can help you accomplish other financial goals:

  • Wipe out high-interest credit card debt: As Bruce McClary, spokesman for the National Foundation for Credit Counseling told The New York Times, “time is not your friend” when it comes to paying down high-interest credit card debt. If the math works out, you can use the money from a lower-rate cash-out refinance to pay off higher-rate card debt. You’ll save in interest expenses and boost your credit score.
  • Take care of a big bill: If you need to handle a large expense—a medical bill or home renovation, for example—cash-out refinance rates are often more attractive than rates for student loans or unsecured personal loans.
  • Lock in a stable rate: Most cash-out refinances have a fixed interest rate, allowing you to lock in a steady payment. This can be a key advantage over variable-rate HELOCs, where your payment can go up if interest rates rise.
  • Lower your tax liability: While certain rules do apply, interest paid on mortgages can be tax-deductible.

Drawbacks of Cash-Out Refinance

As with all financial instruments, cash-out refinances have potential downsides:
 

  • Rigorous eligibility rules: Some lenders have tough cash-out refinance rules, including maximum loan-to-value (LTV) requirements and “seasoning” demands, meaning you must have owned your home for a certain amount of time (usually 12 months) before qualifying for a cash-out refinance.
  • Closing costs: Generally up to 3 percent of the mortgage, closing costs are a significant expense for all refinances, including cash-out refinances. As Holly Johnson writes for Get Rich Slowly, “It may take several years to recoup the costs of refinancing, and it is important to identify your breakeven point.”
  • Your home is on the line: Because your home is the collateral for your cash-out refinance, you could lose the home if you don’t make payments on the loan. You could also run into trouble if the value of your home declines, leaving you with negative equity or “upside down” on the loan.

If you are interested in learning more about cash-out refinancing, it only takes about 3 minutes to get a rate quote. Clara has competitive pricing, and we work to make our process—which is almost completely online—easy for you. If you have any questions, you can chat with one of our licensed Loan Specialists.

Roy Eun
Roy Eun is a licensed Loan Specialist at Clara with experience closing over 450 loans. In his spare time, you’ll find him working on his own software projects, or out on the courts playing basketball.
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