What is a Cash-Out Refinance?
A cash-out refinance replaces an existing mortgage with a new one. Equity from the home is converted to cash, delivered to the borrower and then added to the mortgage balance. The home’s loan-to-value (LTV) goes up and the term is reset.
For example, a house valued at $400,000 with $300,000 remaining on the mortgage has $100,000 of home equity. A borrower might take out $50,000 for home repairs. The first mortgage is paid off and completely and then the property is refinanced into a new mortgage of $350,000, minus transaction costs. A cash out refinance taps into capital reserves that borrowers can use as they see fit.
Reasons to Refinance and Take Cash Out
1. Debt Consolidation
Mortgages tend to cost consumers less money than other types of debt over the long run for two reasons. First, mortgages carry lower interest rates than other kinds of debt. Second, mortgage interest is tax deductible. Thus, consolidating one’s debts into a single mortgage often makes sense. Here are examples of high-cost debt that can paid off with a cash-out refinance:
- Installment loans
- Revolving debt (credit cards)
- Student loans
- Auto loans
2. Home Improvements
For large home improvement and rehab projects, a cash-out refinance will often make financial sense. Often, a new mortgage that carries low interest rate and a term that spreads out payments will make large projects affordable.
But for smaller projects, borrowers may want use a Home Equity Line of Credit (HELOC). While HELOCs typically have higher interest rates, here are some advantages:
- No closing costs
- No change to the rate & term of the existing mortgage
- Tax deductible interest up to $100,000 individually or $50,000 if married and filing separately
The key factor that determines how much interest rates affect the cost of borrowing money is time. So while HELOCs have higher interest rates that first liens, if you plan to borrow a small amount of money and repay the loan quickly, HELOCs can be a better choice. That’s because HELOCs have lower closing costs and do not accrue interest over a long mortgage term.
Here’s another possibility: prevailing interest rates today might be higher than when you took out your original mortgage. You may decide forgo refinancing your existing mortgage that has a lower interest rate. A HELOC at this point might a better option.
No matter what, do the math. For home improvements financed with either a cash-out refinance or a home equity loan, it is best to compare the two scenarios.
3. Pay for College
Education is another kind investment that can be funded using a cash-out refinance. In some cases, built up home equity is one of the few capital reserves available to home owners. A cash-out refinance can also be a financially move because home loans usually have lower interest rates than student loans. Plus, mortgage interest is tax deductible and student loan interest is less likely to be so. Be sure to ask your financial advisor about current IRS rules regarding student loan write-offs.
What makes real estate investing work for many folks is the notion of leverage. When a borrower uses a small amount of money (down payment) to control an asset of much greater value (a home), that is leverage.
Savvy investors know how to take advantage of leverage to invest in several homes and build their real estate portfolios. For example, an investor with $300,000 might put $60,000 down on 5 individual properties rather than buying 1 property valued at $300,000.
Furthermore, when the value of each investment property grows, the investor can periodically refinance them. Cashed-out equity can then be used for down payments on new properties. And so on… This is how leverage increases the number of properties that investors control.
Some investors entertain the notion of using cashed-our proceeds to buy stocks, bonds or other investments. This is extremely risky; markets can turn on a dime and blow up your portfolio. This move is not advised.
5. Elderly Care
Adult children of aging parents may choose a cash-out refinance to help pay for elderly care expenses. Be sure to also check out reverse mortgages, another viable financial tool to pay for elderly care. Reverse mortgages tap into home equity, paying it out to senior homeowners. Seniors get to keep their home. Participants must be 62 years-old or older. Payments are made monthly or in one lump sum.
6. Settle a Divorce
If one of the people involved in a divorce wishes to keep the family home, a cash-out refinance can divide up the equity. Proceeds of the refinance are paid out to the person who will no longer live there, the former co-borrower. Then the new mortgage note will just name the borrower who is keeping the home. The new title will reflect that change as well.
Cash-out refinances can help home owners tap into a capital reserve to help pay for fixing uninsured damages caused by earthquakes, floods, fires, etc.
8. Medical Expenses
A cash-out refinance can also help pay for medical expenses.
When Does it Make Sense to Refinance?
Borrower and Property Eligibility
If you’re looking to refinance you home and pull out equity, a few conditions must be met in order for it to work.
First, you must have significant equity in your home which is determined by the loan-to-value (LTV) calculation. The LTV percentage must meet the requirements of the specific loan program you wish to use. A rule of thumb for standard cash-out refinances is: after adding the new debt and closing costs to the loan balance, the remaining LTV should be 80% to 85%.
In addition to adequate equity, the borrower and property must meet loan program eligibility requirements. FHA, VA, USDA and conventional loan programs have unique guidelines based on several factors, including:
- Transaction type: cash-out, limited cash-out (LCOR), home renovation (HomeStyle, FHA 203K)
- Property type: principal residence, second homes, investment properties, manufactured housing
- Borrower’s credit Score
Closing costs, which can be 3% to 6% of the principal, are another important part of determining whether a cash-out refinance will work. Closing costs include the origination fee, appraisal, inspection, title, escrow, etc. You probably remember many of them from you first mortgage transaction. There are two common ways to handle closing costs for a cash-out refinance:
- Roll them into the principal balance – closing costs are added to the principal balance and must meet specific loan program LTV guidelines
- Lender pays them – known as zero closing cost loans, in exchange for paying your closing costs, lenders charge a higher interest rate
Putting it All Together: Cash-out Refinance Example
Borrowers decide they’d like to pull $50,000 out of their home to cover the cost of a new roof and upgrades to the major appliances. Let’s find out how it looks on paper.
- $400,000 current property value
- $200,000 principal balance
- = $200,000 current equity (50% LTV)
Cash-out and New Mortgage
- $50,000 cash-out
- $250,000 principal balance before rolling in the closing costs
- $7,500 closing costs, rolled into the principal balance
- = $262,000 new principal balance (66% LTV)
Cash-out Refinance Loan Limits
So how much can folks borrow? Most cash-out refinance programs limit the principal limit to current conforming loan limits, which are:
- $417,000 in most counties in the United States
- $625,500 in high-cost counties (major cities and metro counties)
Cash-Out Refinance FAQS
Are proceeds from a cash-out refinance taxable?
No. Proceeds from the refinance are not considered income. Check with your CPA for current IRS rules.
Are there tax deductions when taking out a cash-out refinance?
Yes. But there are two distinctions that need to be made. IRS rules allow you to deduct interest paid on up to:
- $1 million in mortgage debt. This is the common mortgage interest tax deduction we all know and love. It’s debt that comes from buying, building or improving a home.
- $100,000 (or $50,000 if married and filing separately) for mortgage debt used for other reasons. So if you use the proceeds to pay for college, the tax deduction is limited to $100,000/$50,000 not $1M.
Additional deductions for buying points may also be in play. Check with your CPA regarding IRS rules.
Can I cash-out and refinance a rental property?
Yes. Investment properties are eligible for cash-outs. The final LTV limit varies by loan program.
Is an appraisal required?
Depends. Some programs require a property appraisal but streamline (FHA, VA and USDA Streamline) programs do not require them.
What’s the difference between a cash-out refinance and a home equity loan?
A home equity line of credit, or HELOC, is a second lien. It is added on top of a first-position mortgage. Borrowers can draw upon the credit line at any time, such as writing a check or with a special card. Borrowers have access to a maximum credit amount for a certain period of time, known as a draw period. Borrowers are only required to pay interest until the balance is paid in full.
How soon after a purchase can I cash-out some of my home’s equity?
Borrowers will need to wait 6-months closing a purchase before being able to cash-out any of the equity. Some exceptions apply. For example, Fannie Mae allows a cash-out refinance within 6 months of purchase but limits the LTV to 70%. And Fannie Mae can waive the waiting period for properties that were inherited or legally awarded (i.e. divorce, separation or dissolution of a domestic partnership).
Can I use the money for anything I want?
Yes. But you may enjoy the advantage of a tax deduction if the proceeds are spent on home improvements.