Is a cash-out refinance right for you?

What you’ll learn: 

• What is home equity? 
• What is a cash-out refinance? 
• Cash-out refinance requirements
• Cash-out refinance considerations
• How cash-out refinances compare to other loans

Home ownership is a never-ending financial commitment that goes well beyond your initial down payment and mortgage payments. Experts advise saving 1% to 4% of the purchase price per year on routine maintenance — things like having your chimney inspected and refinishing a deck. You'll also need to plan for the occasional (and inevitable!) big-ticket items, such as replacing an old roof or repairing your foundation, both of which can cost several thousand dollars. 

Home improvements count too, and quickly add up — a bath remodel alone can set you back an average of $16,300 whereas a kitchen renovation can cost you upwards of $40,000 (of course, pricing varies depending on the scope of your project and your location).

Even the most diligent savers may not have enough cash reserves to cover those costs. Or you might decide that borrowing is better than depleting your savings. 

What's more, if you purchased your home when interest rates were higher than they are today, you might want to lock into the current going rate. Less interest = lower monthly payments.

One solution that can achieve both those goals: a cash-out refinance, which lets you borrow against your home equity to pay for repairs and renovations while also replacing your existing mortgage. In this deep dive, you'll learn the ins and outs of this financial tool and how you may be able to use it to improve your home and your mortgage terms in one fell swoop. 

What is home equity? 

Before you can grasp how cash-out refinancing works, you need to understand equity as a borrowing tool.

• Equity is your home's current value minus your outstanding mortgage balance. 

That basic definition bears unpacking: In simplest terms, equity is the amount of money you’d get if you sold your home after the lender is paid off (less the usual fees). Equity is built through a combination of your initial down payment, your accumulated mortgage payments, and your home’s appreciation.  

Let's say you purchased a $340,000 home with a $70,000 down payment and an initial mortgage of $270,000. Your equity at the time of purchase is:  

Equity = $340,000 (home value) - $270,000 (mortgage balance) = $70,000

Now imagine that some time has passed and you've whittled that balance down to $200,000 with regular payments. Your new equity would look like this: 

Equity = $340,000 (home value) - $200,000 (mortgage balance) = $140,000

But wait, there's more! Let's assume your home's value has increased to $400,000. That means you have $200,000 in equity. 

Equity = $400,000 (current home value) - $200,000 (outstanding mortgage balance) = $200,000 

Congrats! Now you can take that equity to the bank and use it as collateral for a cash-out refinance or other equity-based financial tools. (We'll discuss how these stack up below.)  

Curious to see the amount of equity you might be able to leverage? By entering your up-to-date mortgage details on your free Realm dashboard, you'll get estimates of how much funding you may be able to access along with current interest rates. 

• Realm tip: While it can be tempting to use your equity to fund a dream vacation or new car, experts recommend doing so only for purposes like home improvements that boost your home value (and further increase your equity). The Realm project planner lets you prioritize renovations, get accurate cost estimates, and see how much value each project will add to your home. 

What is a cash-out refinance? 

You may be familiar with the idea of refinancing your mortgage by replacing your existing loan amount with a new mortgage and new terms. (Read more about refinancing here.)

In contrast, with a cash-out refinance (also known as a cash-out refi), you get to renew the terms of your mortgage (for a period of 15 or 30 years) and access your home equity at the same time. 

So how does it work? With a cash-out refinance, you’re able to get a new loan for more than you owe on your current mortgage. Then, you get to pocket the excess amount in a lump-sum cash payment (minus any refinancing fees). 

Keep in mind that most lenders cap your total borrowing amount to 85% of your home's value. Let’s think back to the scenario from earlier:  

Home value = $400,000 

Outstanding mortgage balance = $200,000

 In this situation, you might qualify to borrow as much as $340,000 (85% of $400,000) in a new mortgage. So how much excess cash would you get to pocket? 

Cash-out amount = $340,000 (new loan) - $200,000 (outstanding mortgage)  = $140,000 

That means that you’d have $140,000 to pay for home upgrades or renovations!  

Check your Realm dashboard to explore the funds that may be available to you in a cash-out refinance. You can also explore potential renovations and get pricing for dozens of projects, all based on your location. Plus, you can see how much each project would add to your home’s value. 

Applying for a cash-out refinance is similar to applying for a conventional mortgage, only with equity as part of the assessment. The general requirements vary by lender but include:

• Home equity: Most lenders will require you to have at least 20% equity in your home, based on current market value, to qualify. Some may also require that you maintain 20% equity after the cash-out refi, meaning you would only be able to borrow up to 80% of your home's current value. 
  
• Length of ownership: Don't expect to apply for a cash-out refinance if you've owned your home for less than 6 months. Lenders like to see that many on-time mortgage payments.
  
• Appraisal value: Because the loan is based on your current market value, a lender will have an appraiser evaluate your home (usually for a fee). 
  
• Credit (FICO) score: Most lenders require a threshold score of 600 or 620. The higher your score, the lower your interest rate can be.
  
• Verification of income: Proof of employment is the default so if you’re self-employed or a contract worker, you'll need to substantiate a reliable source of income (as stipulated by the lender). 
  
• Debt-to-income ratio (DTI): This refers to the percentage of your income that goes toward paying down debt, such as a mortgage (meaning your new amount), car loan, and/or student loans. The target DTI is generally less than 43%.
  
• Loan-to-value ratio (LTV): Your LTV is your outstanding mortgage amount divided by the value of your home. A high LTV corresponds to less equity, and vice versa.

Unable to qualify for a conventional cash-out refi? Consider these alternatives:

• If you have a lower credit score (at least 580) and have lived in your home for at least 12 months, you may qualify for an FHA cash-out refinance. Upfront closing fees are financed into the loan and you'll have to pay an annual mortgage insurance fee.
  
• If you are a veteran or other qualifying individual, a VA cash-out refinance lets you borrow up to 100% of your home’s value. 

Cash-out refi considerations

Two recent trends have created a win-win environment for cash-out refinancing: Home values have been on the rise year over year, allowing you to access greater equity as a borrowing tool, and mortgage rates have dropped to near all-time lows, allowing you to reduce your overall interest payments (as well as your monthly payments).

Has your overall financial situation improved? That can be another reason to do a cash-out refi. Whether you got a raise (or left self-employment for a salaried position), paid down or consolidated your credit card debt, and/or raised your credit score, these and other situations may allow you to get a better rate.

Every financial tool comes with drawbacks. Carefully consider the following before you embark on a cash-out refi:

• Expect to pay 2% to 6% of the total loan amount in closing costs and other fees — as with your original mortgage. (Hint: Shop around and read the fine print.) You may be able to roll those costs into your loan balance to avoid paying them up front, but you'll end up paying interest on them over time. It can be a tricky toss-up.
  
• Because you’re restarting your mortgage, you're also starting over with front-loaded interest payment and may end up paying more total interest in the long run. 
  
• Your monthly payments can increase a little or a lot depending on the new loan amount. 
  
• Cash-out refinance rates tend to be slightly higher (in the realm of 0.5%) than traditional mortgage refinance rates due to the larger loan amount.
  
• There’s always the possibility of home values falling, in which case you could end up underwater, i.e. owing more on your mortgage than your home is worth.
  
• You'll be using your home as collateral to secure the loan with the risk of foreclosure if you’re unable to keep up with your mortgage payments.

Refinance rates fluctuate daily and vary based on your loan amount, location, and credit score. You can find an estimate of cash-out refinance rates from a range of lenders on your Realm dashboard. 

How do cash-out refinances compare?

A cash-out refi is only one way to leverage your equity. A home equity loan or a home equity line of credit, aka HELOC, are others. Each financial tool allows you to access lower interest rates than with personal loans and credit cards.

Here's a quick overview:

• A home equity loan is similar to a cash-out refi in that it’s based on a fixed percentage rate and provides access to a lump-sum cash payout, though you'll end up having to pay a separate monthly payment on top of your mortgage. 
  
• With a HELOC, which functions like a revolving credit card account (including having adjustable interest rates), you have more flexibility in drawing down the balance as needed but are subject to fluctuations in interest rates. You can learn more about HELOCs here.

Neither of these involves your original mortgage. That can be a pro or con depending on whether you can lock into a lower interest rate and have the wherewithal to go through the arduous application process. (It's a mortgage after all!) But for many homeowners, having a two-for-the-price-of-one cash-out refi is worth the time and trouble (and repeat lending fees). 

Needless to say, figuring out which financial tool is right for you is a matter of evaluating your specific situation. The Realm cash-out refinance calculator lets you see how adjusting different factors changes your monthly payment – and have an informed discussion with your financial advisor and prospective lenders.