Cash-Out Refinance Guide: Is a Cash-Out Refinance a Good Idea?

Cash-Out Refinance Guide: Is a Cash-Out Refinance a Good Idea?

We’ll be honest, refinancing can be one of the dumbest things that homeowners do when paying for home renovations. But that will largely depend on your personal financial situation. If you’re trying to lock in a significantly lower rate for your mortgage, a cash-out refinance is a great way to do that.

But for many homeowners, it can mean throwing money away and getting less out of it. We know remodeling can be expensive, and tackling your entire wish list could mean needing to borrow $100,000 or more. This realization is usually what leads homeowners to either put their project on hold indefinitely, or borrow using high interest rate personal loans or credit cards — neither of which should have to happen!

So let’s take a look at how you can use a refinance while remodeling your home to cover your costs, the reasons why many homeowners default to this method of financing their renovation, and other options available to you. 

What is a Cash-Out Refinance?

First things, first: what is a cash-out refinance? A traditional cash-out refi replaces your existing mortgage with a new one with new terms, giving you a lump sum of cash as a result. Essentially, you’re taking out a new loan for more than your current mortgage balance that replaces your existing loan, and allowing you to receive the difference between the old and the new, minus any applicable costs. 

How does a Cash-Out Refinance Work?

In order to use a cash-out refi, you must have sufficient equity built up in your property — but you won’t be able to tap into 100% of this. Typically, lenders will allow you to borrow up to a maximum of 80% of your home’s value, otherwise known as your Loan-to-Value (LTV) ratio.

Therefore, to calculate how much you could take out with a cash-out refinance, you’d multiply your home’s current value by 80%, and subtract your outstanding loan balance from that amount.

As an example, if your home is currently worth $500k, and your mortgage balance is $375k, you could refinance with cash out in the amount of $25k, then use this to pay for home improvements.

Your new mortgage’s balance will be higher than your original one, combining the existing balance with the additional amount that you’re borrowing and closing costs.

The RenoFi Cash-Out Refinance

A RenoFi Cash-out Refinance is a new type of home renovation loan that combines the best elements of a construction loan with a cash-out refi, allowing you to borrow based on your home’s after renovation value.

With a RenoFi Cash-out Refinance, you’ll be able to borrow the most money with the lowest monthly payment for your renovation. And it’s the only type of renovation loan that doesn’t require funds to be disbursed to contractors through a complex inspection & draw schedule process (one of the reasons why contractors hate construction loans.

In fact, if you are considering a cash-out refinance or even a home equity loan to pay for renovations, a RenoFi Loan is the perfect alternative. By borrowing based on your home’s after renovation value, you could potentially increase your borrowing power by more than 11x.

Pros and Cons of a Cash-Out Refinance

The most appealing part of using a cash-out refinance for home improvements is that it allows you to both refinance your first mortgage AND secure the cash you need to tackle your major renovation project by tapping into the equity that you’ve built up.

But similar to home equity loans and lines of credit (HELOCs), you will need sufficient equity for this to be a viable option. And if you’re refinancing into a higher rate, it could end up costing you significantly over the life of your loan.

Additionally, even in cases where you have built up equity, lenders typically cap what you can borrow with a cash-out refi at 80% of your current home value, significantly reducing your borrowing power compared to other options.

So is refinancing a good idea? Here are the pros and cons to consider:

Pros:

• A cash-out refinance allows you to consolidate your current mortgage and the financing needed for your home improvements into a single loan, meaning a single monthly mortgage payment.
• Like your first mortgage, these loans will let you make repayments over a term of up to 30 years. So if you’re someone who purchased their home in the early 2000s and locked in at a much higher interest rate, this could be a good move.

Cons:

• You’ll get no credit for the home value increase that will result from the renovation, the loan is based on the CURRENT home value and thus you must have significant equity available in your home to take cash out.
• You will have a much lower borrowing power than other types of home improvement finance, given that most cash-out refinances only let you tap up to 80% of your home’s current value.
• These loans come with higher closing costs than the alternatives.
• You’ll typically pay a higher rate when taking cash out vs. a non cash-out refinance for a home improvement project.

Eligibility and Qualifications

Just like with a new mortgage, your credit, finances and property will all play a role in whether or not you qualify for a cash-out refi for your home improvement project and how much you’ll qualify for. While these requirements will vary by lender, here’s what you’ll generally need:

• More than 20% equity in your home
• A credit score of 620+
• Debt-to-Income (DTI) ratio of 43% or less (including the new loan)
• Loan-to-Value (LTV) ratio of 80% or less
• Verification of your income and employment 
• A new appraisal to verify your home’s value 

Steps to Apply for Cash-Out Refinance

The steps to apply for a cash-out refi are pretty similar to a regular mortgage loan process, which if you’re looking at this option to finance your project, you’ve already gone through.

1. Shopping around for the best mortgage rates 

2. Choosing a lender and filling out an application 

3. Gathering the necessary financial information and documents to provide your lender, including:

   • Pay Stubs
   • Tax Returns, W-2s & 1099s
   • Homeowners Insurance 
   • Asset & Debt Statements 
   • LTV ratio
   • Credit Score
   • DTI ratio 

4. Your property type (it’ll cost you more to tap equity from a two- to four-unit property, manufactured home, or condo than a standard single-family home). Lenders may charge  higher rates for second homes and investment properties

5. Getting a home appraisal 

6. Your lender verifying all the information provided, known as the Underwriting period

7. Closing on the loan

8. Receiving the cash 

Who Should Consider a Cash-Out Refinance for their Remodel?

The best time to get a cash-out refi is when interest rates are lower than the rate you have on your current mortgage. But since that’s likely not the case for most homeowners given the current climate, there are a couple of other scenarios in which it’s beneficial to use a cash-out refinance for home improvements. Here are a couple of examples of when a cash-out refinance is a good idea:

• You’re going to take on more debt no matter what. The interest rates on a personal loan, credit card, or home equity loan will always be higher than a cash-out refi, so if you’re going to take on debt, it’s always smart to choose the least expensive way to borrow — especially if your renovation project can’t wait.
• You’ll use the funds to build equity. If you know you’re using a cash-out refinance for home improvements that are significantly going to improve your home’s value, you’re using the money to make more money. And in this case, it can have a big pay off later.
• You want to consolidate debt. Credit cards have some of the highest interest rates of any lending option (we’re talking an average of over 23%), so if this is one of your other top options, doing a refinance with cash out to pay for your project could help you save significantly over the life of your loan. 

When is Refinancing NOT a Good Idea?

Many homeowners have much better financing options available to them to help pay for a renovation than refinancing, and this comes down to three main reasons:

1. You’ll Lose That Low Interest Rate

   If you bought your home when interest rates were noticeably higher than they are right now, then a refinance could be a good move. But today, a lot of homeowners are giving up their low interest rates by refinancing — and paying for it big time.

For that reason, many homeowners are avoiding refinancing if they can. In fact, according to the Mortgage Bankers Association, refinance applications made up a little over 60% of all mortgage applications at the end of 2022 when rates were still in the low 3% range. Today, despite a recent uptick, refinances make up less than 30% of all applications. Since January 2022 rates have over doubled, going from 3.22% to a current mortgage rate of over 7.18%.

2. You’ll Have Much Less Borrowing Power

   With a traditional cash-out refinance, you will only be able to tap up to 80% of your home’s current value. And while that may not sound too bad at face value, when you compare it to traditional home equity loans which can go up to 90% of your home’s current value, it’s not quite as appealing. Even further, with RenoFi Loans, you can borrow up to 90% of your home’s after renovation value. This factor alone can make a huge difference to your borrowing power, increasing it up to 11x a traditional construction or refinance loan.

RenoFi offers three different loan options through our lending partners:

• RenoFi Home Equity Loans
• RenoFi HELOCs
• RenoFi Cash-out Refinancing

For starters, let’s compare a traditional cash-out refinance and a RenoFi Cash-out Refinance, assuming that your home is currently worth $500,000, your current mortgage balance is $375,000 and that the after renovation value will be $750,000. Then let’s say the cost of your renovation is expected to be $250,000.

Here’s how much borrowing power you would have across three different types of financing:

If you were to use a traditional cash-out refi to pay for your home improvement project, you could only borrow $25k. Might as well say goodbye to most of that wishlist.

Using a home equity loan could get you $75k, but that’s still significantly less than you need.

A RenoFi Cash-out Refinance, however, could get you up to $300k for your project, based on 90% of your home’s after renovation value. (If math isn’t your thing, that’s $275k more than a traditional cash-out refi).

To put it simply, if you’re going to tackle a renovation project, choose a financing option that doesn’t limit you from getting everything you really want.

3. You’ll Throw Away Money on Higher Rates & Closing Costs
   If refinancing isn’t going to significantly lower your rate, then you’re really just tossing money out the window. Interest rates aside, you’ll pay closing costs for a cash-out refinance as you would any refinance. These typically range from 2-5% of the entire mortgage amount, which for a $200K loan can be $5,000 - $12,500.
   
   When you compare this to less than $900 in closing costs for home equity loans, it’s hard to argue that you’re not just wasting money with a cash-out refi. By choosing a home equity loan over a refinance, you are saving thousands in closing costs.
   
   Whether you’ve spent 5, 10, or 15 years paying into a loan, you don’t end up back at square one without any incentive — like a major reduction in your rate.
   
   Before you choose a traditional cash-out refinance for your renovation project, be sure to do your homework into the alternatives that are available to you. But if you decide you do want to refinance to get that major reduction in your rate but are falling short on how much you need to fund your renovation, consider a RenoFi Cash-out Refinance.

Alternative Loan Options to Cash-Out Refinance

The good news is that you do have options. And RenoFi is here to help you understand those options and determine the best one to finance your renovation project. If you don’t have the personal savings to pay for your project, here are a couple of alternatives:

Home Equity Loan and HELOCs

For homeowners who have built up significant equity in their homes, a traditional home equity loan — also known as a second mortgage — or line of credit (HELOC) can help you get all the financing you need to cover your entire renovation project. These loans are secured by your home meaning they’ll typically have lower rates and more lenient qualifications as they pose less risks to lenders.

But each loan has specific repayment terms, rate structure, and disbursement. A home equity loan allows you to tap into your home’s equity to borrow a fixed amount of money, while a HELOC gives you access to a revolving line of credit to tap into on an as-needed basis, similar to a credit card.

A home equity loan also has a fixed interest rate versus a HELOC’s variable interest rate which can fluctuate based on market conditions over the life of your loan. But with a HELOC, you’ll only start payment on your principal amount once the “draw” period ends (either 10 years or when construction is complete) versus starting payments immediately with a home equity loan.

Construction Loan

Construction loans were originally intended as a way to turn a plot of land into a new home — not to finance renovations. And obviously, building a brand new home carries a lot of risk.

For this reason, there’s a complex set of stringent requirements designed to protect the lender, regardless of whether you’re financing a remodel or a new home construction. In other words, they’re a one-size-fits-all loan, which doesn’t take into account the specific circumstances surrounding the project.

But there are some positives of course. When comparing a construction loan vs a cash-out refinance, you’re able to borrow a lot more money based on your home’s after renovation value, instead of the current value. You’ll also enjoy low rates which are typically in line with the market rate for first mortgages. You also only pay that interest on the cost of the build-out as you make incremental payments to your builder with a construction loan vs a cash-out refinance, in which you’re paying interest on the full amount from day one.

RenoFi Renovation Loans

Home renovation loans let you borrow against the after renovation value of your property, significantly boosting your borrowing power compared to the alternatives.As a result, they’re  the best way to finance the cost of a home remodel for most homeowners.

But there is more than one type of renovation loan available to you, and not every single one will be right for your project.

A RenoFi Loan

The truth is, RenoFi Loans are the perfect way for most homeowners to borrow the money they need to tackle their whole renovation wishlist in one go. This new type of home renovation loan that combines the best bits of a construction loan (low monthly payments, low rates, single close, etc.) with the simplicity of a home equity loan (no complicated disbursement and inspection schedule), while letting you borrow based on your home’s after renovation value. And you won’t need to refinance your first mortgage. 

Considerations and Tips from the Experts

Before you start comparing your options against a cash-out refi, make sure you have a solid cost estimate for your project. We recommend getting at least three from various contractors. And know where you stand financially. Take advantage of LTV to better understand what you own on your current mortgage and how large a refi you could actually do. A loan calculator will also help you understand how much you can expect to pay monthly during the life of your loan.

Then compare how much cash you could access with the projected cost of your renovation. If it covers everything on your wishlist, it may be a good way to go.

Other helpful tips: 

• Check your credit score and be proactive if it’s low. Pay your bills on time, keep spending under control, and work on reducing your debt.
• Factor in closing costs and title insurance costs, as well as application, appraisal, and inspection fees.
•  Make upgrades easy to identify. Be as transparent as possible with your appraiser, giving them a list of all the permanent upgrades being made, as well as estimates and permits. 
• Find a reputable lender. RenoFi can help. We have a large network of great credit unions and can help you find one in your area. 
• Negotiate your loan terms. The longer your loan term, the more interest you will pay, but it will make your monthly payments lower. Shorter terms will likely have lower interest rates, but higher monthly payments. Determine which term length is best for your financial situation and try to negotiate with your lender based on the options presented. Make sure you understand your offer in detail, so you can be confident and knowledgeable when presenting your counter. 

How RenoFi Can Help

Still unsure if refinancing is a good idea? RenoFi can help you determine if a cash-out refi is best for your home improvement project. Check out how much you can borrow with the RenoFi Loan Calculator, and contact our Renovation Advisors to discuss your options. We’re here to help you get your someday home, today — and do it in the most financially responsible way possible.