A homeowner may choose to refinance their mortgage for a number of reasons, including to:
- Obtain a lower interest rate, lower their monthly payment, and save over the life of the loan
- Switch from an adjustable rate mortgage to a fixed rate mortgage to avoid rate increases
- Consolidate debt (like credit cards or auto loans) at a lower interest rate
- Shorten the term of their original loan and pay off their mortgage sooner
- Cancel private mortgage insurance (PMI) by switching from an FHA to a conventional loan
- Turn the equity in their home into cash to pay for home improvements, education costs, student loan debt, the purchase of a car or other big ticket item, or to invest
Cash Out Refinance: The Basics
A cash-out refinance pays off your existing mortgage and enables you to borrow the difference between what you still owe on the property and the current value of your home.
This difference is the equity you have earned as a result of payments you’ve already made and/or any increase in the appraised value of your home.
Now, with home values on the rise, a cash out refinance is an excellent way to tap into your home’s equity and a great alternative to taking out a home equity line of credit.
FHA vs. Conventional Cash Out Refinance
A cash out refinance can be done through a Federal Housing Administration (FHA) or a Fannie Mae or Freddie Mac-backed conventional loan. An FHA cash out refinance has a maximum loan-to-value (LTV) of 85% of the home’s current value and a minimum credit score of 580; a conventional cash out refinance has a lower maximum LTV of 80% and requires a credit score of 620 or higher. Both FHA and conventional loans require an appraisal of the property and borrowers need to show proof of sufficient income and all assets must be verified. The borrower must occupy the property and should have made no more than one late payment in the previous 12 months.
FHA has a higher LTV allowing you to borrow more than a conventional cash out refinance. FHA also requires a mortgage insurance premium should you borrow more than 80% of your home’s value—a conventional cash out refinance does not since you cannot borrow more than 80%. FHA has general debt-to-income (DTI) guidelines—that is total housing costs divided by gross monthly income—of 29% – 41%, but higher ratios may be possible with eligible compensating factors, often allowing up to 50%. The DTI range for a conventional cash out refinance is 36% to 45%.
Finally, whether you choose an FHA or conventional cash out refinance, you will be required to provide all the documentation you did for your original mortgage.