Cash Out Refinance
What is a Cash Out Refinance?
A cash out refinance (also called a cash out refinance loan or cash out refinance mortgage) is a type of mortgage loan that lets you to turn the equity you have in your home into cash, similar to a home equity loan or HELOC. A cash out refinance offers a low-interest way to borrow money for anything, including to pay off credit card debt, make home improvements, go to college, or buy a car.
Cash out refinance loans are attractive to homeowners because they can offer annual percentage rates (APRs) that are half as high as credit cards or personal loans, which can save borrowers tens of thousands of dollars in interest charges over several years. When home prices are on the rise, borrowers may have more equity in their home and therefore have more cash available to borrow through a cash out refinance loan.
Because cash out refinance loans use your property as collateral, they are easier to qualify for than unsecured loans. But this also means your home or investment/rental property could be at risk of foreclosure should you fail to repay the lender.
How Does a Cash Out Refinance Work?
A cash out refinance loan is designed for homeowners that need to borrow cash and are willing to take some of the equity they have built up in their home to get it. These loans use your home as collateral similar to a home equity loan or HELOC, but there are differences that we'll discuss in a moment.
Assuming you qualify, the cash out refinance loan would work by:
1. Paying off your current mortgage,
2. Establishing a new, larger mortgage loan (i.e. the amount of your existing mortgage plus the amount you want to borrow) with a new rate and repayment term, and
3. Giving you the amount you wanted to borrow in one lump sum on closing day.
For example, if your home is worth $250,000 and you owe $150,000 on your mortgage, that means you have $100,000 worth of equity that you could convert into cash through a cash out refinance loan (lenders may let you use up to 80% of your equity or sometimes more depending on your credit rating).
If you wanted to borrow $50,000 in cash, a cash out refinance would pay off your existing mortgage and give you a newly-negotiated mortgage with a principal balance of $200,000 (that's $150,000 for the original mortgage plus the new $50,000 borrowed amount). You'd get the $50,000 in cash when you closed on the loan.
Note: As with any mortgage or refinance loan, a cash out refinance also comes with closing costs that may either be paid upfront or added to your mortgage principal to be repaid over the life of the loan.
With that in mind, you may want to compare potential savings on interest with the amount you may pay toward closing costs to see if a cash out refinance would make financial sense (you can use a mortgage payment calculator for help).
Differences Between a Cash Out Refinance Vs a HELOC
A HELOC, or home equity line of a credit, is tied to your home's equity much like a cash out refinance, but work more like a credit card in that they are revolving credit.
Under a HELOC, the lender gives you a credit limit that you may borrow up to for a set period of time (up to 10 years typically). Instead of getting a one-time lump sum like with the cash out refinance and home equity loan, HELOCs allow you to borrow up to the limit, pay down the principal (or even just make minimum payments), and borrow again up to the limit.
For example, let's say you have a $20,000 credit limit on your HELOC and you borrowed $15,000 of it to make home renovations, leaving you with $5,000 in available credit. If you paid $10,000 toward the principal over time (plus interest charges), your available credit would increase and you would be able to borrow up to $15,000 ($5,000 + $10,000) again from the HELOC.
The annual percentage rates may differ between a HELOC and a cash out refinance, too. While cash out refinance loans typically carry fixed terms (you can take up to 30 years to repay), HELOCs carry variable APRs that follow interest rates. That means if interest rates go up and up, you would have to pay a larger and larger minimum payment on your HELOC, while your payments on a cash out refinance would stay the same.
Comparing a Cash Out Refinance Vs a Home Equity Loan
While both of these loans are tied to the equity in your home, there are differences in how they are structured and what they can offer.
Home equity loans (often called second mortgages) let you borrow against your home's equity by opening up a second loan in addition to your existing mortgage payment. By comparison, a cash out refinance essentially refinances your existing mortgage into a larger mortgage (your existing mortgage plus the cash amount you want to borrow) with a new rate and repayment term. That means if interest rates are higher now than they were when you took out your current mortgage, you may not get as favorable rates when you do a cash out refinance.
Home equity loans usually come with shorter terms (five to 20 years to repay) than a cash out refinance loan (up to 30 years to repay), meaning you may have to make larger payments with a home equity loan but you also may pay less in overall interest charges.
Cash Out Refinance Tax Implications
Is the interest you pay on a cash out refinance mortgage tax deductible? The answer is yes, but only if the loan is used to "buy, build or substantially improve" your home (or a second home you don't rent out) that secures the loan according to an IRS advisory that came out after the 2018 tax law passed. However, you may not deduct the interest you pay from your taxes if you took out the loan to pay off debt or buy something.
Assuming you meet those requirements and are using the money to renovate your home, you may deduct the amount of interest you pay for it from your taxable income to lower the amount you owe for taxes.
The money you have access to after setting up a cash out refinancing is not considered income because the transaction is considered a loan. Therefore you do not need to report the money you receive under a cash out refinance agreement as income on your federal income tax returns.
Can I Get a Cash Out Refinance Loan on My Investment Property?
Yes, if you have a sizeable amount of equity in your property. You will likely need to have a loan to value ratio of 80% (meaning you owe an amount equal to 80% or less of the property's value) to qualify for most lenders. For example, if your rental property is worth $200,000, then you would need to owe $160,000 or less on the property to qualify for a cash out refinance loan.
By comparison, lenders may allow you to refinance up to 90% of the value of your home property (owner-occupied home).