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Everything you need to know about cash-out refinancing

Wondering how you'll ever afford to remodel the kitchen? Cash-out refinancing might be the answer.

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Is it time for a new kitchen?

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What was once your dream home is now in need of some major updates. You can't stand another day in that dingy, dated kitchen crowded with old appliances that don't work. But how do you afford a major renovation on top of the monthly mortgage payment and everything else? A cash-out refi might be the answer. 

In cash-out refinancing, you pay off and replace your current mortgage with a new, larger mortgage. The difference between the old and new mortgage amounts, minus closing costs, goes to you -- in cash.

In order to qualify, you must have equity -- that's the difference between how much your home is worth and how much you owe on your mortgage. Equity is what you're borrowing against. But there are pros and cons, and risks involved. Read on to learn more about cash-out financing and whether it's the right option for you. 

What is a cash-out refinancing?

Cash-out refinancing is a loan option for homeowners who want to cash in on the equity they've put into their property. Unlike traditional refinancing where your new loan replaces your mortgage with a loan of the same amount, a cash-out refi replaces your current mortgage with a larger loan. Most lenders will allow homeowners to borrow up to about 80% of their home's equity. The difference will go back to you in cash and you can use the lump sum any way you choose, including for home improvements and even debt consolidation. 

For example, let's say your home is valued at $300,000 and you still owe $100,000 on your mortgage -- the difference of $200,000 is your equity. If you go with a cash-out refinance, lenders typically require you to maintain 20% of your home's equity, or $60,000 in this case. You'd be able to cash out up to $140,000 to use toward that new kitchen.

Before you do a cash-out refi

  • Check with each lender's cash-out refinance requirements, as they'll differ by institution. For example, some lenders will allow you to borrow only up to 80% of your home's equity, while others will let you borrow up to 90%.
  • Make sure you have at least 20% equity in your home, as this is typically the percentage lenders require before they consider you for cash-out refinancing.
  • Get your credit score to a good place, preferably above 670. Lenders will consider your credit history, score and debt-to-income ratio. They'll also look at your employment and how long you've lived in your house.

Benefits to cash-out refinancing

While cash-out refinancing isn't for everyone, here are some of the potential advantages. 

It can help you consolidate and pay off debt: You can use the difference you're paid from your new home loan to pay off your debt or transfer your debt into an account with a low interest rate. By paying off your debt, you could also improve your credit score.

It helps you make home improvements: Use the cash to finally renovate your kitchen, build an addition or perhaps redo your deck. By investing in your house, you're increasing the value of your home.

It could get you a tax break: Cash-out refinancing could qualify you for a mortgage interest deduction, a tax break that allows you to reduce the amount you pay in taxes based on how much mortgage interest you've paid on your home during that year.

It could lower your interest rates: Whether you go with a traditional or cash-out refinance, you should be able to snag a lower interest rate, particularly if your new loan is larger than your original. Refinance interest rates are generally lower than credit card or home equity loan rates. This could end up saving you thousands of dollars in the long run.

Disadvantages to cash-out refinancing

There are downsides. Here are a few other aspects to consider before committing to a new and larger loan.

It ups your risk of foreclosure: Mortgage loans are secured, meaning they are tied to a piece of collateral, i.e., your home. If you stop making payments on your loan, you could lose your home. That's why using money you receive from a cash-out mortgage to pay off an unsecured loan, such as a credit card, is considered risky.

It'll change your loan terms: Because you're taking on a new loan, you'll most likely have to agree to new terms for your mortgage. You'll want to check the new interest rates, fees and term length before agreeing to the loan.

You could be paying for private mortgage insurance: If you borrow more than 80% of your home's equity, you may have to pay for PMI, which will only add to your expenses. PMI can cost you anywhere from 0.55% to 2.25% of your new mortgage. 

You'll pay closing costs: Just like when you bought your home, you'll need to pay closing costs when you refinance it. This is typically 2% to 5% of your total mortgage.

Alternatives to cash-out refinancing

HELOC

A HELOC, or a home equity line of credit, offers homeowners separate loans with revolving credit instead of one large loan. You'll still have to pay closing costs for a HELOC, however, and your home will still be used as collateral.

Personal loan

Going with a personal loan is another route to access money for your home improvement projects, with the added bonus of not having to use your house as collateral. But because it's an unsecured loan, it'll have much higher interest rates than you'll find with cash-out refinancing.

Reverse mortgage

If you're 62 or older and wanting to make home improvements, you could apply for a reverse mortgage to fund those updates. A reverse mortgage allows you to cash in on your home's equity and relieves you of monthly mortgage payments. But it uses up your equity, which means fewer assets for you and your heirs. And the amount borrowed will have to be paid back when the homeowner either moves out of the home, sells the property or dies. 

Home equity loan

Like cash-out refinancing, home equity loans provide you with a lump sum of cash. Home equity loans won't alter your loan terms, unlike a cash-out refinance, and the interest rate is fixed. But since it's a second mortgage, with a separate payment, that interest rate tends to be much higher than a first mortgage.