Picture this: While lounging on a couch, you munch on one of those crunchy granola bars that spills crumbs literally everywhere. Annoyed at the mess, you remove the cushions to locate the lost crumbs and to your surprise you discover a large wad of cash lying there—totaling $50,000!
That’s how some people think a cash-out refinance works. You buy a house, wait a decade, watch it grow in value, then dig under the cushions to pull out the equity—and spend it on whatever you want!
But the cash part of a cash-out refi isn’t free money—it’s debt. And debt is dumb! So let’s unpack everything you need to know about a cash-out refinance before you do one.
What Is a Cash-Out Refinance?
A cash-out refinance allows homeowners to tap into their home equity by trading in their current mortgage for a larger loan. After paying off their current mortgage with the larger loan, homeowners can use the leftover money (the equity that gets “cashed out”) on whatever their little hearts desire.
Most homeowners use the borrowed equity toward home improvements, debt consolidation or other financial goals that may be unrelated to the house.
Remember, home equity is how much a home is worth minus what’s owed on it. So basically, cash-out refinancing means stealing from your original down payment amount, going backwards on your mortgage payments, and turning your home appreciation into debt. (Hint: These are bad ideas.)
Are Many Homeowners Doing Cash-Out Refinancing?
Since home values have been blasting off like firecrackers in this crazy housing market, more and more homeowners have been dancing to the beat of the cash-out refi drum—in an attempt to take advantage of that home-sweet-home equity.
In fact, between the first and second quarter of 2021, the amount of cash-out refis jumped 13%—representing more than half of all refinance borrowers.1 But just because other homeowners are jumping off a bridge with their equity, doesn’t mean you have to.
How Does a Cash-Out Refinance Work?
A cash-out refinance pretty much works the same as a regular refinance. But instead of shortening your mortgage term or lowering your interest rate, you get a bigger mortgage that also gives you access to cash.
Here are the typical steps of a cash-out refinance:
1. Find Out if You’re Qualified
Every lender has different cash-out refi requirements for borrowers, but here are some common things they check for:
- Plenty of home equity. Most lenders won’t let you cash out all of your home equity—you’ll probably have to leave at least 20% in your home. In other words, you can’t do a cash-out refi that’s more than 80% of your home value in most cases.2
- Credit score of 620 or higher.3 At Ramsey, we teach how a high credit score isn’t a sign you’re good with money—it just means you love managing debt. But if you have a low credit score, focus on improving it by paying your bills on time and avoiding more debt. And whether your score’s high or low, don’t do a cash-out refi!
- Debt-to-income (DTI) ratio lower than 45%.4 A DTI ratio shows how much of your income goes toward debt each month. The higher your percentage, the more of a risk your lender takes in loaning you money.
FYI: If more than 25% of your take-home pay is going toward your current mortgage each month, definitely don’t do cash-out refinancing. Instead, do a regular refi to lower your term and interest rate and follow our 25% rule so you can actually afford the house you’re living in—and pay it off faster!
Pay off your home faster by refinancing with a new low rate!
If you don’t qualify for a refi and your property just isn’t working out for you, it might be time to sell it. To learn about your selling options, work with a real estate agent we trust.
2. Decide Your Loan Amount
If you actually go through with the awful decision to get a cash-out refi (we tried to stop you), you need to figure out how much to borrow. Total up whatever it is you want to do—home renovations, debt consolidation, etc.—so you know how much dumb debt you need.
For home renovations, ask a contractor to provide an estimate. For debt consolidation, total up all your debt balances. Then, add those numbers to your current mortgage balance and that’ll be the total amount you borrow for your cash-out refi. Or—better idea—start a sinking fund for whatever it is you want to accomplish and pay for it with cash, not debt!
Don’t forget: Refinancing a mortgage also comes with closing costs—like when you first took out a mortgage. We’ll cover more on these costs later—but for now, just know they could cut into your cash-out money if you don’t prepare for them separately.
3. Apply and Wait for the Loan to Process
Next, you’ll submit an application to a lender for the cash-out refi. If the lender approves, you’ll likely have to cough up additional paperwork about your financial history—like you did when you first took out a mortgage. Then you’ll hang tight (also your chance to do the smart thing and kill the loan) while your new loan goes through the gauntlet of checks and balances—this will also include a home appraisal.
4. Close on the Loan
On closing day, you’ll sign a mountain of paperwork. Then your new lender will give you the money to pay off your old mortgage. If you didn’t save for closing costs separately, some of your equity cash will be deducted to cover those (boo!). A few days after closing, you’ll get your cash-out portion and can start cranking on your plan.
Example of a Cash-Out Refinance
Here’s an example of a cash-out refi: Let’s say your home is worth $300,000—but you owe $200,000 on it. Thanks to the magic of amortization and appreciation, your equity in the house is now $100,000.
You decide to do a bathroom remodel that costs $40,000. But—whoopsie—you don’t have the cash! So you do a cash-out refinance to crack open the piggy bank on that home equity.
Remember, most lenders will require you to keep at least 20% equity ($60,000) in your house—so you can’t cash out the full $100,000 (nice try, slick). Instead, your lender approves you for a $240,000 loan.
You use $200,000 of it to pay off your old mortgage. But you also forgot to save separately for the $10,000 closing costs, so that cuts into your cash-out money.
Your cash-out amount ends up being $30,000, which means you need to dial it back on your bathroom remodel plans (womp-womp).
Maybe you’ll have better luck in real life. But the real problem here is that a cash-out refi teaches you to stay in debt by borrowing against your house—instead of building long-lasting wealth by paying off your house.
Why Homeowners Do Cash-Out Refinancing
Here are some reasons why homeowners choose to do cash-out refinancing:
- Improve their home
- Consolidate debt
- Get a lower interest rate
- Free up money to invest
- Pay for college education
Get the right mortgage from a trusted lender.
Whether you’re buying or refinancing, you can trust Churchill Mortgage to help you choose the best mortgage with a locked-in rate.
How Much Cash Can I Get From a Cash-Out Refinance?
For most people, the largest amount of money you can get from a cash-out refi is 80% of your home value. Remember, most cash-out refi lenders require you to keep at least 20% equity in your home.
So if you don’t already have more than 20% equity in your house, you probably wouldn’t even be eligible to do a cash-out refi.
And don’t forget, you’ll also have to pay for closing costs—which can cut into your cash-out money if you don’t pay for them separately.
What Are the Fees for a Cash-Out Refinance?
Similar to buying a home with a mortgage, cash-out refinancing comes with fees you pay at closing. These closing costs cover things like attorney fees, lender fees and the home appraisal. Keep in mind, if you try rolling these fees into your new mortgage, it’ll probably up your interest rate.
Cash-Out Refinancing vs. Home Equity Loans
Cash-out refinancing, home equity loans and home equity lines of credit (HELOCs) are all different ways for homeowners to borrow their home equity.
Remember, a cash-out refi involves taking out a bigger loan to pay off your current mortgage—so you can collect the difference in cash.
On the flip side, the home equity loan and HELOC plop a second loan in your lap on top of your current mortgage. The home equity loan allows you to borrow one lump sum of your equity, while a HELOC lets you borrow multiple sums of your equity at a time—like using a credit card.
To choose between these, homeowners usually find out which option gives them a lower interest rate or lower closing costs.
Pros and Cons of Cash-Out Refinancing
To see if cashing out your home equity is worth it, compare the pros and cons:
- Don’t have to sell the house to access your home equity
- Fast way to access a boatload of money
- Interest rates might be lower than with a personal loan
- Turns your home equity into debt
- Keeps you in debt for longer—when you might be close to paying off your house!
- Bigger loan brings a bigger risk of losing your house if you can’t make payments
Is Cash-Out Refinancing Worth It?
Cash-out refinancing isn’t worth it for most people. At Ramsey, we never tell people to borrow money. Getting a mortgage is the only debt we don’t yell at you for. But trading in your mortgage for a bigger one is a dumb idea—especially if your reason for doing so is to pay for things you can otherwise budget and save up for.
If you’re considering a cash-out refi because you’re up to your eyeballs in debt and want to get on top of it, there’s a better way. Use the debt snowball method—it’s helped millions of people become debt-free without getting into more debt!
Bottom line: Many debt products can fool you into thinking you’re making financial progress—but they’re actually just shifting money from one form of debt to another. If you want real wins when it comes to your financial goals, cash is still king!
Work With a RamseyTrusted Mortgage Company
If you want to make a smart move on your mortgage, only do a refinance if it means a much shorter loan term or maybe a slash in your current interest rate. And make sure you’ve already prepared for closing costs.
For help making wise mortgage decisions, contact our friends at Churchill Mortgage. For decades, these RamseyTrusted home loan specialists have coached homeowners like you on how to do a refi that actually helps them pay off their homes faster.