A cash-out refinance is a way to both refinance your mortgage and borrow money at the same time. You refinance your mortgage and receive a check at closing. The balance owed on your new mortgage will be higher than your old one by the amount of that check, plus any closing costs rolled into the loan.
It's sort of like "backing up" your mortgage by taking out some of the money you've paid into it and increasing the mortgage principle owed as a result.
There are no restrictions on how you use the proceeds from a cash-out refinance - you can use it for any purpose you like (though there may be tax consequences - see below). Some of the more common ones are home improvements or repairs, paying off other debts, education costs, starting a business or medical expenses.
Cash-out refinancing is basically a combination of refinancing and a home equity loan. You can borrow the money you need, as with a home equity loan or line of credit (HELOC).
Cash-out refinancing and home equity
To qualify for a cash-out refinance, you need to have a certain amount of home equity. That's what you're borrowing against.
Let's say your home is worth $250,000 and you owe $150,000 on your mortgage. That gives you $100,000 in home equity, or 40 percent of the home's value.
You generally want to retain at least 20 percent equity after refinancing (though some lenders will go lower), so that gives you $50,000 available to borrow.
To borrow that amount, you would take out a new mortgage for $200,000 ($150,000 already owed plus $50,000) and receive a $50,000 check at closing. This doesn't take into account your closing costs, which are 3-6 percent of the loan amount and are often rolled into the mortgage.
Advantages of cash-out refinancing
- Refinance mortgage rates tend to be lower than the interest rates on other types of debt, so it's a very cost-effective way to borrow money. If you use the cash to pay off other debts such as credit cards or a home equity loan, you'll be lowering the interest rate you pay on that debt.
- Mortgage debt can also be repaid over a considerably longer period than other types of debt, up to 30 years, so it can make your payments more manageable if you have a large amount of debt that must be repaid in 5-10 years.
- If market rates have dropped since you took out your mortgage, a cash-out refinance can let you borrow money and reduce your mortgage rate at the same time.
- Mortgage interest is generally tax-deductible, so by rolling other debt into your mortgage you can deduct the interest paid on it up to certain limits, assuming that you itemize deductions.
If you use the funds to buy, build or improve a home, you can deduct mortgage interest paid on loan principle up to $1 million for a couple ($500,000 single). But if you use the proceeds from a cash-out refinance for other purposes, such as education expenses or paying off credit cards, the IRS treats it as a home equity loan, and you can only deduct the interest on the first $100,000 borrowed by a couple ($50,000 single).
Disadvantages of cash-out refinancing
One of the big drawbacks of a cash-out refinance is that you pay closing costs on the entire loan amount. So if you owe $150,000 on your mortgage and use a cash-out refinance to borrow another $50,000, you're paying closing costs of 3-6 percent on the entire $200,000.
For this reason, a cash-out refinance works best if you can also reduce your overall mortgage rate or if you wish to borrow a large sum. For smaller amounts, a home equity loan or line of credit (HELOC) may be a better choice.
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