If you find yourself asking "what is a cash-out refinance," you're not alone. There are many reasons why homeowners might refinance a mortgage: take advantage of lower interest rates, switch to a different loan type, consolidate debt or shorten the length of the loan, for instance. A cash-out refinance can let you do all of that and more: it puts money in your pocket.

A cash-out refinance is a special type of refinancing vehicle that provides borrowers with a lump sum payment in exchange for a larger mortgage. When you apply for a cash-out refinance, your lender will extend you a higher loan amount than your current mortgage, and pay you the difference in cash. Tapping into those extra funds can be very appealing to homeowners who want to cover unexpected expenses or consolidate debt or large-ticket items like college tuition.

Where does that extra money come from, exactly? The lender converts a large portion of the equity you’ve built up in your home — but never all of it, mind you — into cash. That home equity could be gained through monthly mortgage payments, an increase in your property’s market value or both.

Debt consolidation is when you take one or more existing debts, such as personal loans or credit card bills, and pay them off using another line of credit. Ideally, this other line of credit is at a lower interest rate or brings other advantages with it. There's no secret to consolidating debt with a cash-out refinance, however. What you do with the cash from your refinance is up to you; once the money is in your account, you're free to consolidate those existing debts with it.

Why use a cash-out refinance for debt consolidation? For many homeowners, the main driver is the interest rate. While personal loans and credit cards are both options for debt consolidation, they are unsecured loans that often have a much higher interest rate than cash-out refinance rates. Using your home's equity to consolidate higher-interest debts can bring with it all the other advantages of refinancing your mortgage, too.

Cash-out refinance example

Lenders set interest rates on cash-out refis according to numerous economic factors, including inflation, treasury bond movement and housing market trends. The final piece of the puzzle is your financial situation: your existing debt, annual income and recurring expenses, among other considerations. As such, interest rates can be highly variable from borrower to borrower, no matter what cash-out refinance option you choose.

Cash-out refi rates tend to run slightly higher than conventional loans, but for the most part they roughly align with their respective loan type. The most popular cash-out refi loans include:

The total amount of money you can pull out from a cash-out refinance depends on multiple factors:

• The current market value of your home
• The amount of home equity you’ve built up
• The loan amount of your original mortgage
• How large of a home loan your lender is willing to extend

As we outlined in our cash-out refinance example above, the market value of your property, your existing equity and your original loan amount determine what your maximum lump sum payment could look like. But that figure doesn’t account for either closing costs or the amount of equity you’re required to maintain in the property.

One of the most important factors determining your cash-out refi payment is you, the borrower. Your lender will dissect your finances, review your income and assess existing debt obligations to generate a risk profile before approving your refinance. This process includes running a credit report, gathering bank statements and analyzing your debt-to-income (DTI) ratio.

That risk profile will also inform the size of your lump sum payment because your lender will use that information to figure out how large of a loan you should be extended. The less risk you present, the larger a loan you may receive, which would translate into a bigger cash payment.

Every type of home loan, whether it’s a purchase or refi, requires the borrower to pay closing costs and lender fees. A cash-out refinance is no exception. As discussed earlier, homeowners typically spend anywhere from 2% to 5% of the total loan amount on closing costs.

The exact expenses you’ll need to cover to finalize your cash-out refi will vary from lender to lender, but these are most common closing costs and lender fees you may encounter:

• Origination fee
• Appraisal report
• Title insurance
• Title search
• Credit report
• Attorney fee
• Recording fee
• Application fee
• Additional underwriting fee

You may also choose to purchase mortgage points, which lower the interest rate on your refinanced home loan. Although it adds to your up-front financial burden, buying down the rate in this fashion could reduce the amount of interest you owe in the long run.

Are cash-out refinances taxable?

You do not pay taxes on the money you receive from a cash-out refi. On the contrary, your mortgage interest may be tax deductible. If you’re carrying a lot of debt, you won’t be able to deduct interest on credit cards or personal loans from your taxes. Doing a cash-out refi and rolling all of that debt into your mortgage could shrink your tax footprint. For more information, be sure to consult a tax advisor who can guide you through the tax implications of a mortgage refinance.***

Cash-out refinance loans are not exclusive to conventional mortgages. You may find several refinancing options to consider through government loan programs. VA loans, in particular, could be useful for active or former service members in the armed forces.

A cash-out refinance VA loan functions in essentially the same manner as a conventional cash-out refi loan, but with the terms, eligibility requirements and fees you would expect from a VA mortgage. That could mean a lower interest rate on your refinanced home loan since VA cash out refinance rates often undercut conventional mortgage rates. And that, in turn, could lead to lower VA loan payments on your cash-out refi.

You’ll still owe closing costs, as you would with any VA loan, including the VA funding fee. But borrowers can always roll that expense into your monthly mortgage payments. And while the VA itself may have more eligibility requirements when it comes to personal finances, debt-to-income (DTI) ratio and credit scores, your application will still need to meet the qualification benchmarks of a VA-approved lender.

What if you have a conventional mortgage? No problem: You don’t need an existing VA loan to qualify for a cash-out refi VA mortgage. As long as you’re eligible, you can refinance your conventional mortgage into a VA loan and take advantage of cash-out options.

As of today, Guaranteed Rate is now offering up to 100% max LTV (loan-to-value ratio) options on VA cash-out refinances up to $1.5M. Many lenders and cash-out loans cap your LTV at 90% for VA loans, which means a smaller loan for you. However, a Guaranteed Rate VA loan offers cash-out refinances with an LTV option up to 100%, putting more money in your pocket.

Looking for other ways to open up some financial wiggle room without refinancing your mortgage? A home equity line of credit (HELOC) mortgage is a popular way to fund home improvement projects, pay other bills and cover unexpected costs.

In both cases, you trade off of your home equity to open up new financial opportunities. But a HELOC mortgage doesn’t involve refinancing at all, so you retain all of the same loan terms in your existing mortgage. Also, rather than give you money all at once, your lender will open up a line of credit that you can draw from as needed.

Above all else, remember this important distinction between the two loan options: HELOC mortgages require consumers to add a second lien to your home. Your HELOC loan will sit in the second lien position behind your original mortgage. But that means you’ll need to make two mortgage payments every month — one to pay down your first home loan and one to cover your HELOC mortgage.

As you can no doubt see, these two financial vehicles differ in a few key ways, so be sure to review how they stack up against each other:

Cash-out refi

• Convert equity to cash
• One-time lump sum payment
• Replace existing mortgage with a new home loan
• Fixed rate or adjustable rate options available
• Closing costs required
• One mortgage payment

HELOC

• Convert equity to cash
• Open line of credit
• Retain your original mortgage and add a second lien
• Variable interest rates that could rise or fall
• No closing costs required
• Two mortgage payments

You might wonder why go through the complexity of a cash-out refinance when personal loans are widely available? A cash-out refi frequently beats a personal loan in three key areas: loan amount, interest rate and loan term.

Unlike mortgages, personal loans are unsecured loans — that is, there’s no collateral to back them up. As such, these kinds of lenders will offset risk by setting much higher interest rates, extending lower loan amounts and establishing shorter loan terms.

If you have a good amount of equity built up in your home, you could receive a significant payout through a cash-out refi (see our example above). In contrast, personal loan lenders may be hesitant to extend loan amounts that can stand toe-to-toe with a cash-out refi. Personal loans simply aren’t meant to distribute that much money in most cases.

Let’s say you do qualify for a personal loan totalling several tens of thousands of dollars, though. In that case, you’ll likely face a high interest rate — much higher than a cash-out refinance mortgage rate. That would mean paying more in interest over the life of your personal loan.

Speaking of the life of your loan, no personal loan lender will agree to an amortization schedule that spans 30 or even 15 years. With that kind of loan, you’ll be expected to repay the full amount, with interest, within a few years. As a result, your monthly payments could be very high, maybe even on par with your mortgage installments.

On the other hand, turnaround time is one area where personal loans have an undisputed edge. With a personal loan, you could have the money in your bank account within a few days. On average, it can take anywhere from 30-45 days to refinance your mortgage, possible even longer.

Unlike some other loan options like home improvement loans, cash-out refis don’t restrict how you use your funds. Once the money’s in your hands, you can spend it any way you like. That being said, most homeowners gravitate toward cash-out refinance mortgages to cover certain expenses:

• Consolidate high-interest debt
• Renovate your home
• Cover expensive bills, like college tuition, car repairs or medical expenses
• Buy a new car
• Purchase a second property
• Make investments

These are just a few examples. With a potentially large payout and relatively low interest rate, you could use a cash-out refi for just about any expense and come out ahead.

As with any other type of home loan, your lender will insulate itself against risk as much as possible when you take out a cash-out refi. While specific eligibility guidelines will vary depending on a lender’s particular appetite for risk, there are some baseline cash-out refinance requirements that most will adhere to with this kind of loan:

• Borrower must have 20% equity in the home, if not more.
• Your loan-to-value (LTV) ratio should be no higher than 80%.
• Your DTI ratio should be no higher than 43%.
• Your credit score should be no lower than 620.
• You must submit to a home appraisal to check your property’s current market value.

Arguably the most important requirement here is having 20% equity in your home. Since your cash-out refi converts equity to cash, that’s usually non-negotiable. Other criteria will vary on the lender and your financial situation. A sub-620 credit score, for instance, may not be a deal breaker if your income and payment history are strong enough to offset any concerns.

A cash-out refi is undeniably useful, but it may not be the best financial tool at your disposal in every situation. Carefully weigh the pros and cons of this loan type before locking in your mortgage agreement.

Pros

• Turn home equity into cash
• Potentially lower your mortgage rate
• Financing could be less expensive than personal loans and other options
• Lump sum payment is not considered taxable income
• May qualify for tax deductions when used for home renovations

Corns

• Extend the length of your home loan
• Total loan amount will go up
• Must pay closing costs and lending fees
• Funds will not be immediately available