How does a cash out refi work

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• A cash-out refinance replaces your current mortgage with a new, larger mortgage.
• This process lets you turn some of your home equity into cash at closing. But you typically can't take out more than 80%.
• Cash-out refinances can be a good alternative to HELOCs or home equity loans, but there are drawbacks.

If you need access to cash to reach big financial goals, there are plenty of ways to access money, such as using a credit card or taking out a personal loan.

If your home's value has increased since you bought it, you may be able to get the funds you need through a cash-out refinance.

Cash-out refinances come with lower rates than credit cards or personal loans. They also typically have lower rates than home equity loans or HELOCs since they're first mortgages, so they're considered less risky for the lender.

What is a cash-out refinance?

A cash-out refinance is a mortgage that lets you turn the equity in your home into cash at closing. With a cash-out refinance, you take out a mortgage larger than the amount you still owe on your house, and you receive in cash the difference between what you owe on your current mortgage and the new cash-out mortgage.

This is different from a standard rate-and-term refinance, where you replace your current mortgage with a new one of the same size, but with a new rate or term length. This type of refinance can help you snag a lower interest rate or lower monthly payments.

The money you receive with a cash-out refinance can be used however you see fit. Often, homeowners will use this cash for things like debt consolidation or making home improvements.

How a cash-out refinance works

The amount you're allowed to receive in cash may depend on your lender, but as a general rule of thumb, you can't borrow more than 80% of your home's value. This way, you keep at least 20% of your equity in the home.

Let's say your home is valued at $250,000, and you have $100,000 left to pay on your initial mortgage. This means you have $150,000 in home equity.

To determine the maximum amount you could take out, multiply your home's value by 80%, or 0.80. Then, subtract your current mortgage balance to find out how much cash you could potentially get at closing.

250,000 × 0.80 = 200,000

200,000 − 100,000 = 100,000

So in this example, you could take out a loan up to $200,000, pay off your existing $100,000 mortgage, and pocket the remaining $100,000.

Keep in mind that you'll still pay the additional costs that come with taking out a home loan, including appraisal fees, origination fees, and closing costs.

Cash-out refinance pros and cons

The pros of a cash-out refinance

• You could get a lower rate than you're paying now. Just like with regular refinancing, you might be able to secure a lower interest rate when you use a cash-out refinance. It just depends on what your current rate is and whether current rates are higher or lower.
• You'll get a lower rate than you would with a home equity loan or HELOC. Home equity loans and HELOCs are two other types of home loans that let you tap into the equity of your home. If you're trying to choose between a cash-out refinance, home equity loan, or HELOC, know that cash-out refinance rates are usually lower.
• You can choose between a fixed and variable rate. Home equity loans come with a fixed rate, and HELOCs usually have a variable rate. With a cash-out refinance, you can choose between a fixed or variable rate.
• You can use the cash for other goals. There are no rules for how you use the money from your cash-out refinance. You may use it to pay off other debts, start a college fund for your children, or make home improvements, for example.
• You might get a tax deduction. If you use the money from your cash-out refinance to make improvements on your home, you may be able to deduct your mortgage interest payments from your taxes, according to the IRS Publication 936.

The cons of a cash-out refinance

• Your new loan comes with new terms. The new terms of your loan aren't automatically a con — they're just something to look out for. Make sure you understand the new terms of your loan upfront, including things like your term length, interest rate, and monthly payments. If you'd be taking on a significantly higher rate, for example, it might not be worth it.
• You might have to get private mortgage insurance. Private mortgage insurance (PMI) is a type of insurance you have to pay if you've paid off less than 20% of your loan. When you bought the home, you may have been able to make a 20% down payment. Or you may have paid off at least 20% of your home value over the years, so you were able to cancel PMI. But if you borrow more than 80% of your home's value, then you'll have to pay PMI again. PMI can cost between 0.2% and 2% of your loan amount in a year. So if you borrow $160,000, you could pay between $320 and $3,200 annually.
• You may pay more in closing costs and fees than other options. Many HELOCs offer low-fee options for tapping into your home equity. Unsecured options like a credit card may also be a better alternative if you're looking to keep your costs low.
• You could be risking foreclosure. If you can't make monthly mortgage payments, you risk your lender foreclosing on your home. Doing a cash-out refinance might result in higher monthly payments, private mortgage insurance, or a higher rate, which could make it harder to make payments. Before you take out cash, consider whether doing so will be a financial strain.

Should you get a cash-out refinance?

A cash-out refinance can be a good option for borrowers who want to take out a large sum of cash at a relatively low rate. But the trade-off is that you'll be forfeiting some of the equity you've built up over the years, which can be risky. 

But this can ultimately be a smart financial move. For example, many borrowers use their funds to pay for value-boosting home upgrades, which can pay off down the road when they go to sell the home.

Whether a cash-out refinance is right for you depends on your goals, how much money you need, and your overall financial situation.

Cash-out refinance FAQs

Do you pay taxes on a cash-out refinance? Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

No, funds from a cash-out refinance are considered a loan, not income, meaning you won't pay income taxes on that money.

How much can I cash-out refinance? Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

It depends on the lender, but typically you can get a loan for up to 80% of your home's value. Some lenders may allow higher amounts. Keep in mind that you'll only be able to pocket the loan amount minus what you currently owe on your existing mortgage. You'll also need to pay closing costs.

Is a cash-out refinance a good idea? Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

A cash-out refinance can be a good way to pay for projects you need to complete or to pay off high-interest debt. But mortgage rates are relatively high right now, so refinancing means you'd likely be taking on a higher rate than what you currently have.

Remember to look at the whole picture, including your new monthly payment amount. If getting a cash-out refinance would put a strain on your budget, it's probably not a good idea.

Are cash-out refinance rates higher? Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

You may have a slightly higher rate on a cash-out refinance than you would with a standard refinance, since they're riskier for the lender.