What Is Cash Out Refinance?
A cash out refinance is a type of mortgage transaction where a homeowner replaces their existing mortgage loan with a new, larger one, and receives the difference between the new loan amount and the payoff of the old loan in cash. This financial strategy falls under the broader category of Mortgage Finance, allowing individuals to tap into their accumulated home equity. Homeowners typically pursue a cash out refinance to access funds for various purposes, such as home improvements, debt consolidation, or other significant expenses. Unlike a standard refinance that primarily seeks to reduce an interest rate or change loan terms, a cash out refinance specifically involves extracting cash from the property's equity.
History and Origin
The concept of leveraging home equity has evolved alongside the development of the broader mortgage market in the United States. Early mortgage lending practices, prior to the 1930s, often involved short repayment periods and substantial down payments, making homeownership inaccessible to many. Significant federal interventions during the Great Depression, such as the creation of the Home Owners' Loan Corporation (HOLC) in 1933 and the Federal Housing Administration (FHA) in 1934, aimed to stabilize the housing market by introducing longer-term, fully amortized loans and mortgage insurance22, 23. These innovations, detailed in "A Short History of Long-Term Mortgages" by the Federal Reserve Bank of Richmond, gradually fostered the accumulation of home equity for a wider segment of the population, setting the stage for later financial products that allowed homeowners to access that equity19, 20, 21.
As home values grew over decades, particularly during periods of economic expansion, the equity built up in properties became a significant asset. The availability of products like the cash out refinance became more prominent as a means for homeowners to tap into this accumulated wealth, especially during periods of low interest rates when refinancing became more attractive.
Key Takeaways
- A cash out refinance replaces an existing mortgage with a new, larger one, allowing the homeowner to receive the difference in cash.
- The amount of cash received is based on the homeowner's available home equity and the lender's loan-to-value (LTV) ratio limits.
- Funds obtained from a cash out refinance are not considered taxable income, as they represent a loan rather than earned revenue.
- Common uses for the cash include debt consolidation, home renovations, or financing large expenses.
- While offering financial flexibility, a cash out refinance increases the principal balance and total interest payments over the life of the loan.
Interpreting the Cash Out Refinance
Understanding a cash out refinance involves evaluating its impact on a homeowner's financial standing. The primary interpretation centers on how much home equity can be converted into liquid funds. Lenders typically allow borrowers to cash out up to a certain loan-to-value (LTV) ratio, meaning the new loan amount (including the cash out portion) cannot exceed a predetermined percentage of the home's appraised value. For example, if a lender has an 80% LTV limit on cash out refinances, a home appraised at $400,000 could have a new loan up to $320,000. If the existing mortgage balance is $200,000, the homeowner could receive up to $120,000 in cash (minus closing costs).
Interpreting the benefit also requires considering the prevailing interest rate environment. A lower interest rate on the new loan compared to the old one can help offset the increased principal and potentially lower the monthly payment, even with more debt. Conversely, a higher rate would make the transaction more expensive.
Hypothetical Example
Consider Sarah, a homeowner whose house is valued at $500,000. She has an existing mortgage loan with a principal balance of $200,000 and an interest rate of 4.5%. Sarah wants to finance a major kitchen renovation estimated to cost $80,000.
She explores a cash out refinance. Her lender offers a new mortgage at 5.0% and has a maximum loan-to-value (LTV) ratio of 80% for cash out transactions.
- Calculate maximum new loan: 80% of $500,000 (home value) = $400,000.
- Determine available cash: $400,000 (new loan) - $200,000 (existing mortgage payoff) = $200,000.
- Receive cash: Sarah can take out up to $200,000 in cash, which is more than enough for her $80,000 kitchen renovation. She decides to take out $100,000.
- New mortgage terms: Her new mortgage will be for $300,000 ($200,000 old balance + $100,000 cash out), with a 5.0% interest rate and a new amortization schedule, typically over 15 or 30 years.
This allows Sarah to fund her renovation without taking out a separate, potentially higher-interest loan, rolling the cost into her mortgage.
Practical Applications
A cash out refinance offers several practical applications for homeowners seeking financial flexibility:
- Home Improvement: One of the most common uses is to fund significant home renovations, additions, or repairs. By using the cash for a capital improvement, the homeowner can increase the property's value and potentially deduct the interest on the refinanced portion of the loan (subject to IRS rules).
- Debt Consolidation: Homeowners often use a cash out refinance to consolidate higher-interest debts, such as credit card balances or personal loans, into a lower-interest mortgage loan. This can simplify payments and potentially reduce overall interest expenses. A Consumer Financial Protection Bureau (CFPB) report highlighted that paying off other bills or debts was the most common reason for cash-out refinancing between 2014 and 202117, 18.
- Education Expenses: Funding college tuition or other educational costs can be another application, providing a potentially lower-cost alternative to student loans or personal loans.
- Investment Opportunities: Some homeowners might use the funds to invest in other assets or businesses, aiming for a higher return than the cost of their mortgage interest.
- Emergency Funds: Creating a larger emergency fund can be a reason, providing a safety net for unforeseen circumstances.
It is important to note that while the cash obtained from a cash out refinance is not considered taxable income, the deductibility of interest payments on the cashed-out portion depends on how the funds are used15, 16.
Limitations and Criticisms
Despite its utility, a cash out refinance comes with notable limitations and risks:
- Increased Debt: The most significant drawback is that it increases the principal balance of the mortgage, leading to higher monthly payments or a longer repayment period. This means more interest payments over the loan's life.
- Risk of Foreclosure: By converting unsecured debt (like credit card debt) into secured debt (mortgage debt), homeowners put their home at greater risk. If financial difficulties arise, the inability to make mortgage payments could lead to foreclosure. The Consumer Financial Protection Bureau (CFPB) has cautioned that paying non-mortgage debts with mortgage debt can increase the risk of foreclosure if payments become unsustainable12, 13, 14.
- Closing Costs: A cash out refinance involves new closing costs, including origination fees, appraisal fees, title insurance, and other charges, which can amount to thousands of dollars and reduce the net cash received. These costs are often rolled into the new loan amount, further increasing the debt.
- Eroding Home Equity: While providing immediate liquidity, repeatedly using a cash out refinance can deplete a homeowner's home equity, which is a significant source of wealth and a buffer against financial shocks. A lower equity stake can limit options during future financial needs or if the home's value declines.
- Tax Implications for Non-Qualified Uses: As outlined by the IRS in Publication 936, interest payments on the portion of a cash out refinance not used for home acquisition or capital improvement may not be tax-deductible9, 10, 11. This means if the cash is used for personal expenses or to pay off consumer debt, the interest on that specific portion of the loan won't qualify for the home mortgage interest deduction, potentially negating one of the perceived benefits.
Cash Out Refinance vs. Home Equity Line of Credit (HELOC)
While both a cash out refinance and a Home Equity Line of Credit (HELOC) allow homeowners to access their home equity, they differ significantly in structure and application.
| Feature | Cash Out Refinance | Home Equity Line of Credit (HELOC) |
|---|---|---|
| Loan Structure | Replaces existing mortgage loan with a new, larger one. | A second mortgage, separate from the primary mortgage. |
| Funds Received | Lump sum of cash at closing. | Revolving line of credit, accessible as needed. |
| Interest Rate | Typically a new fixed or adjustable rate for the entire new loan. | Often a variable interest rate during the draw period. |
| Payment Impact | New, usually higher, monthly payment on a larger principal balance. | Additional monthly payment for the HELOC, based on usage. |
| Closing Costs | Full closing costs associated with a new mortgage. | Generally lower closing costs, sometimes none. |
| Term | New 15-year or 30-year amortization period for the entire loan. | Typically a draw period (e.g., 10 years) followed by a repayment period (e.g., 20 years). |
The choice between a cash out refinance and a Home Equity Line of Credit (HELOC) depends on the homeowner's needs. If a large, one-time sum of cash is required and a potentially lower, fixed interest rate for the entire debt is desired, a cash out refinance may be suitable. If ongoing access to funds is preferred, or if the homeowner wants to keep their original mortgage terms, a HELOC might be a better fit.
FAQs
Is the cash received from a cash out refinance taxable?
No, the cash you receive from a cash out refinance is not considered taxable income by the IRS. It is viewed as loan proceeds, which must be repaid, rather than earned income7, 8.
How much cash can I get from a cash out refinance?
The amount of cash you can receive depends on your home's appraised value, your existing mortgage balance, and the lender's maximum loan-to-value (LTV) ratio for cash out transactions. Lenders typically allow borrowing up to 80% of the home's value, from which your existing mortgage balance is subtracted to determine the maximum cash out, minus closing costs.
What can I use the cash for?
The funds from a cash out refinance can be used for almost any purpose, including home improvements, debt consolidation, educational expenses, or other significant personal needs. However, the deductibility of interest on the cashed-out portion for tax purposes may depend on how the funds are used, as outlined by the IRS4, 5, 6.
Will my mortgage payment increase with a cash out refinance?
Generally, yes. Since a cash out refinance increases your overall principal balance, your monthly mortgage loan payment will likely be higher, even if you secure a lower interest rate than your previous loan.
Does a cash out refinance affect my credit score?
A cash out refinance involves a new credit inquiry and potentially a new loan structure, which can temporarily impact your credit score. However, if the funds are used to pay down other high-interest debts, such as credit cards, it can lead to a long-term improvement in your credit utilization and overall credit score over time1, 2, 3.