What Is a Cash Out Refinance?

The term cash out refinance has become a popular term in mortgage lingo (although less so after the financial crisis of 2008 and 2009) and is an attractive financial option for some homeowners.

In general, a refinance is defined as: to finance again; specifically, to provide or obtain a new loan or more capital for.

So, when you refinance, you take a brand new mortgage out to replace your old or existing mortgage. When you refinance, since you are taking a new loan, there are some costs involved. For example, you may have to pay closing costs, loan originate fees, title fees, document fees, application fees, and assorted other costs. These costs can total a few hundred dollars.

When you do a cash out refinance, you are doing the refinance for a specific purpose: to get cash out of your home. How does this work, you may wonder? What is a cash out refinance and why does the bank allow you to take cash out of your house?

How a Cash Out Refinance Works

Most people who own a house have some "equity" in their homes. Equity is defined as:

1. the value of property beyond the total amount owed on it in mortgages, liens, etc.

So, that means it is the part of your house you actually own. For example, assume your home is worth $150,000 and you owe $100,000 on the house. This would mean you have $50,000 of equity.

When you do a cash out refinance, you "tap into" or release that equity in your home.

Developing Equity

You develop equity in a number of different ways when you own a house. First, most people have equity in their homes because they put a down payment on the house. It is standard in the mortgage industry to require a 20 percent down payment. Although many lenders will waive the requirement, if you put down less than 20 percent on your home, you have to pay a special type of insurance called "private mortgage" insurance in order to protect the lender's investment, since it is a riskier investment.

When you put that down payment down on a house, you have instant equity. Assume, for example, that the house is worth $150,000. When you put 20 percent down, you are putting $30,000 down on the house. The bank lends you the other $120,000 and you have $30,000 of equity in the house.

You also develop equity when your house goes up in value. If your $150,000 house increases in value to $155,000, you instantly have $5,000 in equity. This is one of the reasons why real estate can be such a great investment, as long as property values go up. You don't have to do anything in order to make money on your property and to develop more equity.

You also develop equity when you pay down the principal on your mortgage. Each mortgage payment you make goes to cover both principal and interest. The longer you pay on your mortgage, the more your principal goes down. When principal goes down, the amount of interest you pay each month also goes down with it (since principal is calculated by multiplying your interest rate by the amount you owe). So, for the first few years that you are paying your mortgage, most of your monthly payments go towards principal. However, in the last few years, most of your monthly payments go towards interest.

This equity that you earn from these three sources increases your net worth. However, some people decide they want to take that money out of their homes.

Cashing Out

If you have $50,000 of equity in your home, you may want to "cash" that money out. This means you want to reduce your equity, which is not a "liquid" or movable asset, and turn it into cash. You do this by refinancing your mortgage in order to take equity out.

Assume that you own a house valued at $150,000 and you have $50,000 in equity. If you want to do something else with that $50,000 instead of having it be tied up in your house, you can refinance your existing $100,000 mortgage. The bank may lend you $130,000, for example (80 percent of the amount that the home is worth). This way, you'll be increasing your mortgage during the refinance, decreasing your equity in the home, and turning that equity into cash.

When the bank gives you that $130,000 refinance, you can use $100,000 of it to pay off the original mortgage and that leaves you with $30,000 cash. You thus have effectively "cashed out" the equity in your house and you now have cash in hand.