What Is a Cash-Out Refinance?

Mortgage refinancing involves replacing your existing loan with a new mortgage that has different terms. Some borrowers do this to secure a lower interest rate, others tap into their home equity with a cash-out refinance and use the funds for debt consolidation or home renovations. Though some borrowers may have interest rates locked in below 3%, many have fixed interest rates that are much higher. According to data from the Federal Housing Finance Agency, 17.2% of outstanding mortgages have an interest rate of 6% or above. 

If you’re considering a cash-out refinance to access your home’s equity or get better loan terms, here’s how it works, including pros and cons, and what other options are available.

What is a cash-out refinance?

A cash-out refinance replaces your existing home loan with a new one, complete with new terms. It’s different from a standard refinance; it typically involves the borrower taking out an amount greater than what’s owed on the home. The additional amount can be used for a variety of purchases, such as paying off medical debt or funding post-secondary education.

How does a cash-out refinance work?

A cash-out refinance loan works like a mortgage loan: Upon approval, you take out a new home loan that immediately replaces the original mortgage. 

The key difference is that the homeowner borrows more than what’s owed on the initial mortgage. The additional amount is taken from the equity in the home, or the amount that’s already been paid off. 

Borrowers can only take out a specific maximum, which is the loan-to-value ratio (LTV). A borrower can’t borrow against all of their home’s equity. Many LTV ratios are 80/20: The borrower can take out 80% of the equity, leaving 20% untouched. 

Benefits of a cash-out refinance

Cash-out refinance loans are a reliable option for qualified homeowners who are overcoming specific financial hurdles. Jim Breeze, senior vice president of mortgage product development at PNC Bank, specifies that better-qualified borrowers tend to benefit more than homeowners who meet the minimum qualifications for a cash-out refinance.

“Homeowners with strong equity, good credit, and a need for cash may benefit the most from cash-out refinancing,” he says. “Homeowners who plan to own the home long-term benefit most, as refinancing can help secure a lower mortgage rate or better loan terms but will come with closing costs.” 

Breeze also notes that refinancing in a dropping rate environment is even more beneficial, but that no matter how low the rates go, the borrower must still be prepared to take on the financial burden.

“In a dropping rate environment, refinancing can lock in lower payments. The key thing to remember is to always borrow responsibly.” 

Benefits of a cash-out refinance include lower interest rates, longer terms, the ability to switch from an adjustable-rate mortgage to a fixed-rate mortgage, and using the equity in the home to fund other financial goals. 

Potential drawbacks of a cash-out refinance

While lower interest rates and leveraging existing equity can be beneficial for some borrowers, cash-out refinance loans also have their drawbacks.

An assessment of cash-out refinance mortgage rates conducted by the Consumer Financial Protection Bureau (CFPB) between 2013 and 2023 notes that these mortgages were a significant portion of all refinances when interest rates were rising. 

Breeze notes that “a rising rate environment makes refinancing less attractive unless the need for cash outweighs the cost. As with all loans, only take a cash-out refinance for necessary, well-planned expenses.”

The CFPB’s data also highlighted that borrowers of these loans had lower incomes and credit scores than borrowers of non-cash-out refinances. One tip most financial advisers suggest is to increase your credit score or lower your debt-to-income ratio prior to applying for a mortgage, including refinancing, to receive the best rates available.

Potential drawbacks of a cash-out refinance include tapping into equity on a home that’s lost market value, paying additional closing costs, taking an unnecessary hit on your credit score, and paying a potential prepayment penalty for paying off the initial mortgage loan early.

Cash-out refinance vs. other home equity options

A cash-out refinance isn’t the only option for securing a lower rate or completing other financial plans. Breeze recommends that borrowers explore all options available, even those they weren’t aware of before. 

“Before settling on a cash-out refinance, homeowners should explore other financial options, such as a home equity loan, a home equity line of credit (HELOC), or a personal loan. Each solution offers homeowners different terms, and choosing the right option likely depends on their financial goals and situation, as well as repayment preferences.”

Refinance

Refinancing your home lets you replace your original mortgage loan without using your home equity. This new loan has a different interest rate and term length. While it is possible to take out a small payment between 1% of the new mortgage or $2,000 (as per the guidelines set by Freddie Mac), borrowers typically aren’t relying on this payment to cover other expenses. 

HELOCs

Like a cash-out refinance, a home equity line of credit (HELOC) lets you borrow against your home’s equity. Unlike a one-time refinance, you’re able to repay and draw against your HELOC for multiple years. 

“The draw period differs between lenders, but is typically five to 10 years. During this time, you can borrow as needed and make interest-only payments,” Breeze says. “After that, you enter the repayment period, paying back both the principal balance and interest.”

Home equity loans

A home equity loan borrows against the equity of your home. Instead of refinancing your existing mortgage, the equity acts as the loan. You’ll receive a lump sum and have to repay this amount according to the loan terms. 

Breeze says that a home equity loan can be useful for borrowers in a rising interest environment. 

“Home equity loans provide a lump sum up front with a fixed rate. If opting for a cash-out refinancing would raise the interest costs, keeping the current mortgage and dipping into home equity could be a more viable option,” Breeze says.

Personal loans

Of course, some financial goals can be met without the need to consider a cash-out refinance. A personal loan is a type of loan borrowers can use for purposes such as debt consolidation or home renovations. It’s a lump sum that the borrower pays back according to the loan terms. The key difference is that the loan has nothing to do with the home’s loan or equity. 

As Breeze states, “A personal loan avoids using the home as collateral. Personal loans offer fixed payments, but typically may offer shorter terms with higher rates.”

Eligibility requirements for a cash-out refinance

Each lender sets its own eligibility requirements for a cash-out refinance, but typically, the refinance pays off the existing loan, which must be at least a year old at the time of refinancing. The borrower must have also been on the title of the home for at least six months. 

Steps to obtain a cash-out refinance

While some lenders may have variations in their processes — for instance, if you’re applying through a brick-and-mortar financial institution or using an online-only lender — the process is generally similar to when you applied for your initial mortgage loan:

1. Check your credit report and history to ensure that there are no inaccuracies.
2. Speak with your current lender about a cash-out refinance.
3. Shop around, compare, and negotiate with other lenders for better potential terms.
4. Select a lender and make sure you understand all of the details. 
5. When you agree to the terms and are approved for the loan, you’ll receive a new amortization schedule to replace your original home loan’s repayment schedule.

Common uses for cash-out refinance funds

Breeze says borrowers can use cash-out refinance funds for multiple purposes, including:

• Home improvement projects
• Consolidating debt
• Covering major expenses

The CFPB’s research shows a similar trend: Many borrowers refinance to pay off other debts including credit cards and auto loans, make necessary home repairs, or begin new construction around the home. Whatever you decide to use the funds for, be it investments, furthering education, or funding a second home purchase, understand that you must repay them on time or risk losing your home.

Tax implications of a cash-out refinance

Many homeowners can deduct some of the costs associated with a cash-out refinance. These are typically the points paid, deductible as mortgage interest. Unfortunately, while the points paid on the original home loan can be deducted in the same year, the refinanced loan’s points paid must be deducted over the lifetime of the loan.

Another tax implication of a cash-out refinance involves what the excess funds were used for. Borrowers can deduct the points paid in some situations, such as when the money was used for home renovation. Closing costs are typically not deductible. 

Is a cash-out refinance right for you?

A cash-out refinance is useful for consolidating debt, funding large purchases, and replacing existing loan terms, but it won’t be the best option for all homeowners. Taking out a mortgage is one of the largest purchases you’ll ever make; refinancing increases your outstanding debt and reduces your equity. Speak with multiple lenders before making a decision, as other options may be better suited to achieve your financial goals.