What is a cash-out refinance — and is now a good time for one?

Have a mortgage refinance on your mind? If you’re considering a mortgage refinance to take advantage of low rates or to free up cash, a cash-out refinance could be your best bet. But what is a cash-out refinance exactly?

In a nutshell, it's a way to borrow money against your home equity by taking out a new mortgage loan that returns some of your equity to you in the form of cash to handle home repairs or renovations, consolidate debt, or fund another financial goal.

If you're confident on all these fronts, here's a closer look at how cash-out refinancing works.

Ordinarily, refinancing a mortgage means getting a new home loan to replace your existing one. This new loan can have a shorter or longer repayment term and a different interest rate than your previous loan.

Cash-out refinancing works differently. With this type of loan, you get a brand-new loan in place of your old one, plus you withdraw part of your home equity at closing. This home equity is paid out to you as cash in a lump sum. You can then use the money as you see fit.

It’s different from a home equity line of credit (HELOC) or a home equity loan. With a HELOC, you still borrow against your home equity. But instead of a lump sum, you have access to a line of credit you can draw against as needed. A home equity loan offers lump sum funding, but it's essentially the equivalent of a second mortgage on your home.

Cash-out refinancing doesn't mean you can withdraw all of your home equity. Instead, lenders limit you withdrawing a set percentage of equity in cash.

Typically, this is capped at 80% of your total loan-to-value (LTV) ratio. This is where you have to do a little math to figure out how much equity you have available and how much you can actually borrow against.

A Veterans Affairs or VA refinance loan is an exception to the rule. If you have an existing VA loan, it's possible to refinance up to 100% of your home's value with a cash-out option.

It's also worth mentioning that you also need to meet the other requirements set by your mortgage lender to qualify for cash-out refinancing. Aside from checking your LTV ratio, your lender can also consider your credit scores, income, and debt-to-income ratio when deciding whether to approve you for a cash-out refinance.

If you're weighing the possibility of a cash-out refinance loan, it's helpful to think about potential refi expenses, like interest rates and closing costs. Cash-out refinance rates can be fixed or variable , depending on the type of loan you're getting. Compared to a purchase loan (the mortgage you get when you buy your house), a cash-out refinance could have a higher interest rate, whether you're getting a 15-year loan or a 30-year loan.

In terms of closing costs, a cash-out refi loan can have the same closing costs as any other type of mortgage, though these can vary by lender. These costs can range from 2% to 5% of the loan amount, so you'll need to factor that into your budget when considering whether to refinance. The closing timeline can take anywhere from 45 to 60 days to complete.

Aside from the interest rate and closing fees, it's also important to consider what your new monthly payment may be after cash-out refinancing. You can run the numbers through our refinance calculator or talk to a mortgage lender about what your new payment may add up to.

Refinancing your mortgage doesn't mean you're required to cash-out your equity. If you want to refinance your home loan without taking cash-out, you can do that.

You'd still get a new mortgage loan to replace the old one. The new loan may have a different loan term and interest rate compared to your original mortgage. The difference is that unlike a cash-out refinance, you wouldn't receive any cash at closing.

With a cash-out refinance, it's possible that your new mortgage could have a lower interest rate than your original mortgage. That scenario can become reality if interest rates have dropped significantly since you purchased your home.

Cash-out refinancing can also put money in your hands when you need it. If you have high interest credit card debt, for example, using a cash-out refi for debt consolidation could make sense if you're able to get a lower interest rate on the loan.

You could also use a cash-out refinance loan to meet other financial needs, such as covering medical expenses in a financial emergency , paying for a wedding, or paying for college so your child can avoid student loans. This type of refinancing gives you flexibility in how you can put your home equity to work. Because of this, it’s also a great way to fund a home improvement project — big or small.

Additionally, cash-out refinance loans can yield tax breaks for some homeowners. If you're using a refinance loan to get cash for home improvements or renovations, the interest on the loan could be tax-deductible.

While cash-out refinancing could make sense, there are some potential downsides to keep in mind.

First, your home serves as the collateral for the loan. If you're unable to make your monthly payment and end up defaulting, your mortgage lender could initiate a foreclosure proceeding against you. That means losing the home and severely damaging your credit score.

Next, cash-out refinancing isn't free, and the closing costs can easily add up. Additionally, costs can also increase if your new loan has a higher interest rate. A higher rate means more interest paid total over the life of the loan.

Finally, cash-out refinancing creates new debt since you're increasing the amount you have to repay to your mortgage lender.

If you’re considering refinancing your home loan, remember to shop around and compare rates from at least a few mortgage lenders before you sign the dotted line — that way, you can feel confident you’re getting the best rate possible.

Whether you’ve been spurred by low interest rates of late, or you’re interested in borrowing cash from your home’s equity so you can finally make those renovations you’ve been dreaming of, now could be the time for a cash-out refi.