Cash out refinance: Definition and how it works

What is a cash out refinance? Is a cash out refinance ever a good idea? Learn all of that, and more, in this article

Cash out refinance: Definition and how it works

Because mortgage debt is generally good debt, a cash-out refinance can be one of the cheapest ways to access money. And you can use it for pretty much anything: home improvements, college tuition, or high-interest debt consolidation. Plus, there are often tax benefits.  

But it is not always a slam dunk.  

If taking a cash-out refinance will threaten your financial health in the long term, you may want to rethink your options. In this article, we will define cash-out refinance and help you weigh the benefits against the risks, to give you a better idea if this is the right move for you. To the mortgage professionals who typically visit our website, this article is part of our client education series and can be a good resource to send to your clients. 

What does a cash-out refinance do? 

A cash-out refinance replaces your current mortgage with a new, larger mortgage, allowing you to access the difference between both loans in cash. In other words, a cash-out refinance allows you to convert home equity into money; the amount is based on the equity you have built up in your property. The funds that you get from a cash-out refinance can go toward pretty much anything, like home improvements or consolidating high-interest debt, among other financial needs. 

A cash-out refinance is similar to a mortgage refinance, or a rate-and-term refinance, in which you replace your current home loan with a new loan for a shorter loan term, a lower interest rate, or both. The major difference with a cash-out refinance is that you can take out some of your home equity as a lump sum.  

Generally, refinancing is a popular option if you want to replace your current mortgage with a new one to extend more favourable terms, as mentioned. The more favourable terms that make refinancing a popular option also include: 

  • Lower monthly mortgage payments 
  • Lower interest rates 
  • Remove or add borrowers from the loan obligation 
  • Renegotiate the periodic loan terms  
  • Access cash from the equity in your home 

How cash-out refinance works 

Essentially, cash-out refinancing lets you use your property as collateral for new home loans plus extra money. This is done by taking out a new mortgage for more money than you owe on your current mortgage. Using your home equity to gain access to your funds is an easy way to get money for emergencies, expenses, and even leisure.  

If you want to pursue a cash-out refinance, you will have to find a lender who is willing to work with you. Your lender will look at your current mortgage terms, your credit profile, and the balance needed to repay the home loan. Then, based on an underwriting analysis, the lender will make you an offer.  

You would then get a new home loan that repays your previous loan and get locked into a new monthly installment plan. The amount of money that is more than the mortgage payoff would then be given to you in cash. 

If you opted for a standard refinance, you would not see any of the money in hand—you would simply see a decrease in your monthly payments. While the money from a cash-out refinance can be used in any way you like, most use it for larger expenses like educational fees or medical bills, to consolidate debt, and emergency funds.  

But remember, you have less equity in your home when you use a cash-out refinance, meaning your lender is taking more risk on you, resulting in interest rates, fees, and closing costs that are more costly than for a standard refinance. If you have a specialty mortgage such as a VA loan (US Department of Veteran Affairs), for instance, you can refinance through better terms with lower rates and fees than non-VA loans.  

Is a cash-out refinance a good idea? 

When you repay your mortgage, you build equity in your property, which, incidentally, is one of the main reasons mortgage debt is considered good debt. Using a cash-out refinance, you can access that equity in cash now rather than having to wait until you completely pay off your mortgage or sell your property. 

But the ability to access your equity in cash is not the only benefit. Here are some of the other pros of a cash-out refinance

  1. Access to lump sum 
  2. Predictable payments  
  3. Increase home value 
  4. Possible tax deductions 
  5. Mortgage debt = good debt 

Let’s take a closer look at each to help you decide if a cash-out refinance is the right financial move for you: 

1. Access to lump sum 

By unlocking the home equity you have already built, you get the funds you need to upgrade your home or pay down any debts you have. This access to a lump sum is one of the more significant benefits of a cash-out refinance.  

2. Predictable payments  

When you take a cash-out refinance, you will most likely go with a 30-year fixed-rate mortgage, meaning you will know when your monthly mortgage payments will be. This can be a major benefit, since you will be able to more easily get your finances in order. With other options for accessing home equity, this is not always the case. If you went with a home equity line of credit, for instance, you would likely have to go with a variable rate instead of a fixed rate.  

3. Increase home value 

The home improvements that you make will likely increase your property’s value—and further build your home equity—depending on the kind of renovation you fund with your cash-out refinance. Especially effective are bath and kitchen remodels.  

4. Possible tax deductions 

At tax time, renovations can also have a significant impact. Generally, you can deduct the interest you pay on your mortgage if you use the money for home improvements that boost the value in your property. Home improvements can also boost your tax basis in the property, reducing your capital gains tax liability if/when you sell the house.  

5. Mortgage debt = good debt 

What is the cheapest form of money available? The answer, for many consumers, is mortgage debt. This is true especially when you compare mortgage debt to personal loans, credit cards, or other types of debt, since mortgages usually offer a combination of favorable terms and lower interest rates.  

What is the downside of a cash-out refinance? 

While there are many benefits, there are about as many downsides of a cash-out refinance. You may want to rethink your financial plans if you are worried about the impact that a cash-out refinance will have on your long-term financial health.  

For instance, if you want to sell your property soon, a cash-out refinance may not make financial sense, because you will be on the hook for the bigger balance at closing. Before you chose a cash-out refinance, it is critical to weigh the benefits as well as the downsides. Here are a few of the downsides of a cash-out refinance: 

  1. You owe more 
  2. Closing costs  
  3. The amount of equity required  
  4. Potential debt spiral 
  5. Unfavorable tax implications  

1. You owe more 

Your overall debt load increases when you use a cash-out refinance. In other words, the extra money you received will be a larger burden financially, regardless of how close you were to repaying your initial mortgage in full. If you were to sell, it would also reduce your proceeds. 

2. Closing costs 

When you take a cash-out refinance, you have to pay closing costs like you did when you took out your original mortgage—and they can be a significant cost. The credit check, appraisal, and other costs can be as high as 2% to 4% of the loan amount. 

3. The amount of equity required 

After a cash-out refinance, most lenders typically need you to maintain 20% equity at minimum in your property (there are, however, exceptions). You may not qualify if you purchased your property with a low-down payment loan. 

4. Potential debt spiral 

While accessing home equity to fund home renovations can be a great move, it could also be a major downside if you cash out to pay off high-interest debt on credit cards. First, you should ensure you have addressed the spending problems that led you to accumulate that high-interest debt in the first place. If you do not, you could find yourself in what is termed a debt spiral, where the same mistakes get you deeper and deeper in debt.  

5. Unfavorable tax implications 

Your tax liability may increase with a cash-out refinance, since it means you take on additional mortgage debt. It is therefore important to consult with your accountant or tax expert.  

A cash-out refinance could also be used to make you and your clients money. Twitter 

Why is cash-out refinance riskier? 

A cash-out refinance can be riskier for a few reasons. One of these reasons is if your life circumstances change after the refinance and you are unable to afford to pay off the new loan—therefore putting your home at risk. When the risk increases, either you or the lender has to bear the responsibility for it. 

Another reason that may make a cash-out refinance riskier is if your home value decreases, which may be out of your control. In this case, a cash-out refinance may result in you owing more money than your property is worth. However, it is true that this is less of a risk given the 80% loan-to-value (LTV) ratio requirement that came into effect after the 2008 mortgage crisis, when lenders were more casual with aggressive borrowing. 

Alternatives to cash-out refinance 

If a cash-out refinance is too risky for you, there are alternatives, such as: 

  • Home equity line of credit (HELOC) 
  • Home equity loan 

Let’s take a closer look at each to better understand your options: 

Home equity line of credit (HELOC) 

A HELOC is a separate loan and creates a second lien on the home, while not actually functioning like a loan. Instead, it is a line of credit that you can access when necessary, plus it comes with minimal closing costs. Depending on the terms (five or 10 years, for instance) you only have to repay the interest on the amount you borrow. After that initial period, you must start repaying the principal plus interest. 

Home equity loan 

A home equity loan is essentially a second mortgage, by a different name. Because you take out a second loan against your home equity, you have to make an additional payment every month. Home equity loans are attractive because you can choose a fixed interest rate. Just be sure not to borrow more than you can afford to pay back.  

Read more: Home equity loan: Everything you need to know

Is it smart to use a cash-out refinance? 

A cash-out refinance can be a smart choice for many homeowners. Even when mortgage rates are rising, the collateral involved in a cash-out refinance (your property) makes it less risky for lenders, who are then able to keep refinance rates more affordable.  

All of this means that a cash-out refinance is one of the best—i.e., cheapest—ways to pay for major expenses. Some of the reasons that make it smart to use a cash-out refinance include: 

Home improvement. If you use a cash-out refinance to pay for home improvements, you can deduct the mortgage interest from your taxes. First, make sure that these projects significantly increase the value of your home. 

Investments. If you want to buy an investment property or to build your retirement savings, a cash-out refinance would be a smart move.  

Learn the 5 ways to buy an investment property in this article.

High-interest debt consolidation. Compared to other kinds of debt such as credit card debt, refinance interest rates are usually significantly lower. The money from a cash-out refinance will allow you to repay these debts and instead repay the loan with a single, low-cost monthly payment.  

College education. Accessing your home equity to pay for college education can make great financial sense if the refinance rate is less than the rate for a student loan.  

As we have seen, there are many benefits to a cash-out refinance, from using the lump sum to increase the value of your home to predictable mortgage payments to potential tax deductions. But there are risks, especially if you find yourself debt spiralling because you have not gotten to the root of your financial woes. Whatever you decide, it is important to know what you’re getting into first.  

Do you have experience with doing a cash-out refinance? Let us know in the comment section below.