What is a cash-out refinance and how does it work?

A cash-out refinance is a type of mortgage refinance that turns a portion of your home equity into cash. With a cash-out refi, you’ll swap your current mortgage for a bigger mortgage, pocketing the difference between the two loans (your current one and the new one) in a lump sum. You can use these funds for any purpose, whether it’s for a home renovation, college tuition or other expenses.

Cash-out refinancing works much like any other refinance: You’ll apply for a new mortgage, the lender will order an appraisal of the home and — if you’re approved — you’ll receive the new loan, which’ll pay off the original, and then repay that new loan over time in installments.

Many mortgage lenders offer cash-out refinancing — here are some of our picks. While you might be offered a good deal or perks with your current lender, shop around and compare refinance rates and fees between a few lenders.

Cash-out refinance requirements

As with any mortgage, you must meet certain financial criteria to qualify for a cash-out refinance. Here are a few of the general requirements:

• Credit score: Most cash-out refinances require a credit score of 620 or higher.
• Debt-to-income (DTI) ratio: Your DTI is a measure of your monthly debt payments against your income. Most lenders limit your DTI ratio to 45 percent for a cash-out refinance.
• Equity: You’re required to keep a minimum of 20 percent equity in your home. (The big exception to this is if you’re doing a VA cash-out refinance.)

How much equity do you need to do a cash-out refinance?

In general, you’ll need at least 20 percent equity in your home to do a cash-out refinance. This is less risky for the lender, and also prevents you from leveraging the entire value of your home.

Some lenders, however, allow you to refinance with less. While this can net you more money when you cash out, it also means you’ll have less equity in your home, which could put you in a precarious financial position, or even put your mortgage underwater if home values were to decline.

How much cash can you get in a cash-out refinance?

Many lenders allow you to tap up to 80 percent of your home’s current value in a cash-out refinance. Conventional and FHA cash-out refinances are limited to 80 percent of your home’s value, but with a VA cash-out refinance, you can get up to 100 percent. USDA loans don’t allow for cash-out refinancing.

Let’s say your home is valued at $400,000 and you have $100,000 left to pay on your mortgage. If you wanted to get $30,000 for a renovation, you’d cash out $30,000 and add that to your $100,000 balance, for a new loan totaling $130,000. You’ll receive the cash shortly after closing.

Pros and cons of cash-out refinancing

Cash-out refinancing has several pros and cons:

Pros of cash-out refinance

• Access to cash: You can turn your equity into a liquid asset you can use to cover home repairs or pay for college tuition, or anything else you need it for.
• Increase your home value: If you use a cash-out refinance to renovate your home with a kitchen remodel or an addition, for instance, you could grow the value of your home.
• Lower interest rates: Mortgages come with lower interest rates when compared to credit cards, personal loans and other forms of debt. You can use a cash-out refinance to pay off this higher-interest debt, which could save you money on interest and better your credit score by lowering your credit utilization.

Cons of cash-out refinance

• Owing more money: A cash-out refinance replaces your old mortgage with a new, larger mortgage. This means you’ll owe more, and could have a higher monthly payment.
• Closing costs: You’ll have to pay for some closing costs like you did for your original mortgage.
• Foreclosure risk: Unlike credit cards and personal loans, mortgages are secured debt, with your home as collateral. If you’re unable to make your mortgage payments, your home will eventually be subject to foreclosure.

How to get the best cash-out refinance rate

Start by focusing on your credit score and DTI ratio. Paying down your debts can help improve both of these factors.

Next, use the rate table above to find lenders and compare offers from at least three. Assess both the interest rate and APR you’re quoted, noting that APRs are higher because they include points and fees.