How does a cash-out refinance work: Requirements, Tax Implications and Limitation
Updated: Aug 18, 2020
Those of you that own a home and have been paying on your mortgage for some time now have probably learned about mortgage refinancing. Whenever you refinance your mortgage you essentially replace your old loan with a newer one.
The new loan ideally would have lower interest rates and your monthly payment may be lower depending on the terms of the refinance. For homeowners that need funds quickly, there may be a good option for you: Cash-Out Refinancing.
What Is Cash-Out Refinancing and How Does It Work?
In the same sense that a mortgage refinance replaces your old loan with a new one, a cash-out refinance replaces the old one with a new loan whose principal owed is more than what was already owed on the mortgage. The loan is higher because you are tapping into your home’s equity in order to get some cash out. Hence the term cash-out refinance.
Now, obviously the bank won't necessarily hand you literal cash in hand, but the funds made available from tapping into your home’s equity usually get deposited directly into your checking account.
A cash-out refinance will typically have slightly higher interest rates than if you had just refinanced your mortgage outright. Lenders and various online loan programs typically let you take out up to 80% of the value of the equity in your home.
Let’s illustrate this with a quick example:
You own a home that’s worth $250,000 and you currently owe $100,000 on your mortgage. You’ve decided that you want to renovate your kitchen and buy your son a new car as a graduation present. You have calculated your renovations plus the new car to come out to be $40,000.
So you call up a lender and apply for a cash-out refinance. The $100,000 you owe on your home PLUS the $40,000 you need will be rolled into a new mortgage. Your new mortgage now has a balance of $140,000 and you’ve now got $40,000 for those home renovations and to buy your son that new car he wanted.
The new $140,000 mortgage in the example above may have a higher or a lower interest rate than the previous mortgage did. The monthly payments may be higher or lower, depending on the terms and length of the loan.
What Are The Requirements For A Cash-Out Refinance?
First and foremost you have to be a homeowner with a mortgage. If you own your home free and clear with no mortgage, you will need to seek out a home equity loan, not a cash-out refinance.
Second, you must have equity in your home. If you just moved into a home 6 months ago, you likely have no equity in your home unless you had a substantial down payment or your property value has increased significantly.
Your home will likely either be appraised or the lender will have an appraiser pull comps in your area to ensure they have the correct valuation on your home.
Third, lenders typically will only lend you no more than 80% of the value of the equity in your home. If you have a $150,000 home and owe $100,000 on it, you’d be hard pressed to find a lender that will give you more than $40,000 for a cash-out refinance.
$150,000 value -$100,000 owed = $50,000 equity. 80% of $50,000 equity = $40,000
Finally, you will have to deal with typical lender qualifications as you would with just about any other type of installment loan. Even though your house is being used as collateral, lenders are going to take a look at your credit history, your income, and your debt-to-income ratio.
Reasons For Getting A Cash-Out Refinance
There are slight variations in the law that change from state to state, but for the most part and within reason, you can use the extra cash for anything. With that being said, most people use a cash-out refinance for large purchases.
Some of the most common reasons homeowners take advantage of cash-out refinances are:
● Pay off high-interest debt, usually credit card debt. If you’re a homeowner that’s in over your head in debt, this is one of the best decisions you can make. The interest on your refinance will undoubtedly be lower than many of your credit cards and possibly your other debt too. You can use the cash made available during the refinance process to pay off your high-interest debt. Note: Depending on your current debt-to-income ratio, if you’re using a cash-out refinance to pay off revolving debt, like credit cards and lines of credit, some lenders may require you to close these accounts down after they’ve been paid off.
● Home repairs and remodeling are another common reason homeowners will utilize the equity in their home with a cash-out refinance. Whether your house simply needs repairs to make it liveable, you want to make upgrades as an investment for when you sell it in the future, or you simply just want it to be nicer, lenders are always willing to lend against your equity if you’re improving the house that’s being used as collateral. Note: Some states have laws describing how home repair equity payments must be distributed. For example, Texas law states that if you’re using the equity in your home for repairs, the lender must give the check directly to your third-party contractor.
● Tuition and schooling are often paid for by tapping into the equity of your home. Many parents rightfully feel it’s important to invest in their child’s future with a good education. Whether it be a state-run university, or the fanciest preschool you can find, if you’ve got equity then the lender will help put your child through school. Note: The interest rates on student loans for college students can vary, be sure to look closely so you can ensure you’re going with the option that has the lowest interest rate, not necessarily the lowest monthly payment.
Potential Downsides Of A Cash-Out Refinance
Cash-out refinancing doesn’t always work out to be the best option for some homeowners looking to make use of their home’s equity. Here are some of the potential risks you can face:
Higher Mortgage Interest Rate - Getting cash out from a refinance may very well raise the interest rate you were already paying on your mortgage.
Private Mortgage Insurance - You may have paid your mortgage down enough so that you cancelled your PMI. A cash-out refinance may require you to put PMI back on your home.
Drags Out Mortgage Debt - You could have had 5 years left before you owned your home free and clear. Depending on how much cash out was needed, the terms of your new cash-out refinance loan may be 10, 15, even 20+ years.
Home Equity As A Piggy Bank - Sure you might use it now for something important, but oftentimes homeowners fall into the trap of thinking their home’s equity is essentially a piggy bank. Once they’re familiar with the process, it’s much easier for them to smash the piggy bank open (aka tap into the equity) and take some crazy vacation or go on a shopping spree.
Risk Losing Your Home - Anytime you add additional debt as a lien against your home, you heighten the risk of losing your home should something happen that puts you in a position where you cannot properly repay the loan back.
Tax Implications Of A Cash-Out Refinance
It doesn’t matter how much cash you draw from the equity in your home, you will not be taxed on that amount. Simply put, the amount of cash you get out is not income and will not be taxed as such.
In fact, you may be able to deduct any interest paid on your cash-out refinance, regardless of what you used the equity for. Almost everyone qualifies for these tax deductions but it’s best to check with a tax professional just to be safe.
The exception to these two rules are for refinances that are $750,000 and above. If you’re doing a refinance of such a substantial amount, your lender should be well versed in the specifics.
Limited Cash-Out Refinance vs. No Cash-Out Refinance
With a limited cash-out refinance, the loan amount will be slightly higher because the costs of processing the loan get rolled into the new mortgage total, as opposed to the homeowner paying them out of pocket. By reconciling the differences between the estimated loan payoff and the actual loan payoff, the borrower is able to receive 2% of the new loan value OR $2,000, whichever is less. Hence the cash out that is received is limited.
A no cash-out refinance is when a homeowner refinancing their mortgage but doesn’t take advantage of the available equity. Oftentimes this is done to take advantage of lower interest rates or, if the homeowner is having trouble with their mortgage payments, to refinance with longer terms so that the monthly payments are now lower.
The outcomes are fairly similar between types of loans, it simply all boils down to what your long-term goals are when it comes to your mortgage and the equity that you’re looking to access.
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