Unlock the benefits of cash out refinance: A Homeowner's Guide

If you’ve purchased a property using a mortgage loan, you know that you only own the portion of your property’s value that is not covered by the home loan. The part that you own is called “equity,” and represents what you would make if you sell your property after your current mortgage lender is repaid. 

Although your home equity may be considered an asset in the abstract, what financial benefit does it serve in your day-to-day? Well, if you find yourself with a large upcoming purchase, medical or credit card debt, or other major expenses, you could use a cash out refinance to convert your home equity into usable funds.

What to know about a cash out refinance loan

• A cash out refinance mortgage is a way to get a new loan term, interest rate, and loan amount, plus additional cash—and repay it with a single mortgage payment
• Homeowners must have built equity in a property before cash out refinancing could be a viable loan option
• A home equity loan is not the same as cash out refinancing

Understanding Cash Out Refinance

It’s never wise to take on new expenses or debt without understanding what you’re getting into. So let’s examine how cash out refinancing works, what you need to consider if you want to pursue a cash out refinance, and what the cost of that extra cash might actually be. 

What is a cash out refinance?

A standard mortgage refinance loan is a loan that you take to pay off and replace your original loan, usually to get better terms and save money on interest or payments. A standard mortgage refinance may have different loan terms than your current mortgage, but the total loan should be the equivalent of what you already owe your mortgage lender. 

A cash out refinance, on the other hand, means that you borrow more than the balance of your existing mortgage. It’s specifically designed to pay off your existing mortgage and give you extra cash for debt consolidation or other expenses. Where does this cash come from? It’s taken from the equity that you’ve built up in your property. You basically give that equity to the lender in exchange for cash, and then you buy the equity back through your new monthly mortgage payment.

How does a cash out refinance work?

Imagine that your property is currently valued at $300,000 and your current mortgage balance is $200,000. That means that you should have $100,00 in home equity. Pretend you also have some higher-interest debt that you accumulated due to an injury and related expenses (totaling $40,000), but you don’t want add to the number of monthly expenses you have. You’d prefer to pay for these items outright, but you don’t have $40,000 in cash that you can access to pay for these bills.

But you do have that $100,000 in home equity. 

In this scenario you would apply for a cash out refinance for $240,000. That sum includes $200,000 to pay off your original mortgage and $40,000 to be deposited into your checking account or given to you as cash, which you can then use to repay other creditors.

Your $240,000 cash out refinance loan would likely have different terms than your original loan, including a different interest rate or mortgage term, and your monthly mortgage payment might be different than your original loan, but you would have successfully consolidated your debt without adding additional monthly payments to your expenses. 

Your new loan would then replace your original mortgage, so you’d still only have one monthly mortgage payment. $200,000 from the cash out refi would be applied to pay off your first mortgage and the additional $40,000 would be deposited to your bank account or given to you as cash. 

Remember: when you use a cash out refinance you trade a portion of your home equity for a loan. That means that you may have to regain that equity over time by paying down your refinance loan. If you default on a cash out refinance the risks are the same as if you default on your current mortgage, and your property could be subject to foreclosure.

What are the benefits of a cash out refinance for homeowners?

A cash out refinance could be for you if you’ve built up a good amount of equity in a property and need cash for higher-interest debt consolidation, to make home repairs or improvements, to pay for tuition, to cover a large upcoming expense, or similar. Depending on your timing and other factors, your refinance rates might even have better terms than your existing loan, which could save you money on interest. But as with all financial decisions, there may also be risks, so it’s important to understand the situation in full before you proceed.

Qualifying and Applying for Cash Out Refinance

What are the requirements for a cash out refinance?

Different lenders may have different equity requirements for you to qualify for a cash out refinance loan. It’s wise to know what your numbers are and to discuss this with the lenders who you are considering before you submit an application.

The mortgage lender will likely have a requirement that a borrower not fall below a certain credit score or exceed a certain debt-to-income (DTI) ratio or loan-to-value percentage. This means that if you have more debt than the lender believes you can reasonably pay off based on your income, or if your existing mortgage already covers a large percentage of your property’s value (and you have low equity), a mortgage lender may see you as a borrower who already owes more in debt than you have in assets.

Different lenders will also have different combined loan-to-value (CLTV) ratios that will dictate how much you’re able to borrow against your equity. In other words, you may have $100,000 in home equity but a mortgage lender’s CLTV means that they won’t give you more than a certain percentage of that in cash. (Discover® Home Loans, for example, offers cash out refinancing up to 90% CLTV—so you could take a cash out refinance loan for $270,000, or borrow up to $70,000 against your equity.) Compare different lenders to make sure that you’d be able to get the cash you need if you do a cash out refi with them.

What are the steps to qualify for a cash out refinance?

Typically, a mortgage refinance loan is going to require similar information as what you had to provide when you applied for your current mortgage, and the overall process could be similar.

1. Collect up-to-date information and documentation about your income, credit history, debt-to-income ratio (DTI), and other personal financial information.
2. Know the current value of your home. Don’t just assume that it’s worth the same amount as it was when you purchased it—make sure you have a recent appraisal or a general idea of what it will appraise for when the lender evaluates it.
3. Understand the terms of your current loan, including how much you still owe, whether it is a fixed rate mortgage or an adjustable-rate mortgage, your monthly mortgage payments, and how much you are paying in interest or projected to pay over the life of the loan.
4. Explore the cash out refinance options available for your situation and calculate what you might get. Different lenders will have different structures, including closing costs percentages, CLTV ratios, and loan terms. Compare what’s available to you so you can make the most informed choice about your mortgage lender.

Cash Out Refinance vs Other Financing Options

Now that you know a little more about cash out refinances, you can compare it to other refinancing options, like a conventional loan, with a little more clarity.

Cash out refinance vs personal loan: which is better for homeowners?

Whether a personal loan is better for your circumstances than a cash out refinance is going to be a personal decision, but these are some things to consider as you compare the loan types.

1. How much could you borrow, and does it cover the needs you have that are prompting you to seek the loan? Be aware that a portion of the total loan amount may need to be applied to closing, origination, or other costs.
2. What are the personal loan interest rates you’d qualify for compared to the interest rate on a cash out refinance?
3. What would your total monthly payment be in either case? Think about how much you would pay each month with your existing mortgage plus the monthly payments of a personal loan, and for how many years you’d make both those payments, compared to the single monthly mortgage payment you would make with a cash out refinance. 
4. How much would the loan cost you over its lifetime? Look at the total repayment cost of your existing mortgage plus a personal loan and compare it to the total repayment cost of the cash out refinance loan.
5. Do the different loans have extra costs associated with them? Some cash out refinance loans and some personal loans may include additional expenses that you will want to factor in to the overall cost of the loan—make sure you consider all fees, penalties, and other features that a specific bank may include in their loan products.

How does cash out refinancing compare to a second mortgage?

A cash out refinance involves the equity you have in your property, but it is very different from loans that use equity but are considered a second mortgage. A second mortgage, quite literally, means that the loan you take out using your home equity as collateral is separate from the existing mortgage that you already have, whereas the refinance bundles them together as a single new mortgage. The most common “second mortgage” loans are home equity loans or a home equity line of credit (HELOC), and though they function differently, with either one you end up with an additional monthly mortgage payment with separate terms in addition to your first mortgage.

What are the pros and cons of cash out refinance vs home equity loan?

If you know that you want to use the equity that you have built in your home, but you can’t decide whether a home equity loan or a cash out refi loan is a better choice for you, it’s a good idea to get really clear about your objectives.

Most simply, a cash out refinance may be best if you can get a lower mortgage rate than your current mortgage and also want to consolidate higher-interest debt into a simply monthly payment.

A home equity loan might be better for you if your current home loan terms are great and you don’t want to touch it and you want a separate lump sum of cash to manage and repay on its own schedule.

To dig deeper, here’s how Discover® Home Loans options compare.