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Have you ever felt like all the money you need is tied up in your house?
If that sounds familiar, you might want to explore a cash-out refinance, which is when you take out a new mortgage that’s for more than what you owe on your home — and the lender cuts you a check for the difference.
Basically, a cash-out refinance gives you a way to liquidate some of the equity in your home. And since mortgage interest rates are at historic lows right now, a refinance that locks in a lower rate can help you save on interest.
You have options for how you can use the extra cash you get, too. You can use it to pay for a home-improvement project or to pay off credit card debt, for example. But with a cash-out refinance, taxes change depending on how you use the money.
Ultimately, a cash-out refinance could give you cash flow when you need it for renovations or other expenses. “It could be extra relevant this year, because one of those renovations could be a home office,” says Lauren Anastasio, Certified Financial Planner at SoFi. “If people are thinking about tapping into their home’s equity to add or modify a home office, that’s absolutely a scenario that would make the cash-out portion — and all of your mortgage — interest deductible.”
What Is a Cash-Out Mortgage Refinance?
A cash-out refinance is when you take out a loan for an amount that’s more than what you own on your home. But the benefit is that you get the difference between your current equity in your house and the new loan amount in the form of a lump sum of cash.
Let’s say you have a $400,000 mortgage. You’ve paid off $150,000, which is the equity you’ve now invested in the property. This leaves you with a balance of $250,000 — ignoring interest.
You can, for example, refinance your existing $250,000 home loan into a $300,000 mortgage. You go back to owing $300,000 on your home, dropping you back to 100k of equity. But your lender cuts you a check for that $50,000 difference. Suddenly, the money that was tied up in your property is cash-in-hand.
“The low-interest rate environment we’re currently in is going to drive people toward the cash-out refinance, ” Anastasio says. And quarterly refinance statistics from Freddie Mac back that up.
Is a Cash-Out Mortgage Refinance a Good Idea?
A cash-out mortgage refinance is worth it if you’re looking to turn some of the equity you have in your home into liquid funds. In other words, it’s an option if you need cash.
The situation varies a bit depending on how you use that cash, though:
- If you use the cash to improve the value of your home, you can deduct up to $750,000 of mortgage interest — or $375,000 if married filing separately.
- If you use the cash for anything else, you won’t be able to take a deduction on the interest you pay on the cash-out portion of your newly refinanced mortgage.
The second scenario might still make sense for you, though — even if you lose the tax perks. “You don’t necessarily want your equity just sitting there, locked up in the house,” Anastasio says. “If you can use your cash-out to pay off high-interest debt, it could be a great way to improve your cash flow and your credit.”
But a cash-out refinance isn’t right for everyone. Anastasio says these cash-out refinances aren’t a good idea in three cases: “If the interest rate on the refinanced mortgage is higher than the rate they currently have, if they’re going to struggle to afford the higher payment, or if they’re considering selling the property in the near future. There will be closing costs involved and we want to make sure we’re in the property long enough to recoup that,” she says.
In fact, one expert said a cash-out mortgage refinance is almost never a good idea. Chris Hogan, financial expert, national best-selling author, and host of The Chris Hogan Show, actually never recommends it.
“Here’s why,” Hogan says. “The goal when you bought this home was to pay this thing off. The goal isn’t to buy a home, it’s to own a home. You’re pulling out equity that you’ve earned through the years through appreciation and the payments you’ve made. Don’t go backward.”
Particularly, he doesn’t recommend it for debt-consolidation purposes — in other words, paying off credit card debts or personal loans. “Why would you take your largest monetary asset and secure unsecured debt?” he adds.
That’s a hefty grain of salt to take as you consider a cash-out refinance. If you still decide it’s worth it to you to free up some liquid funds and lock in the low interest rates we’re seeing right now, the next consideration is how to qualify for one.
How Can I Qualify For a Cash-Out Refinance Mortgage?
There’s one main hurdle you’ll need to jump to get a cash-out mortgage refinance. You’ll need to maintain a specific loan-to-value (LTV) ratio. That means the amount you’re borrowing can’t exceed a certain percentage of your property’s appraised value.
In a cash-out refinance, this comes down to equity. “For a home purchase, the minimum down payment could be as low as 3.5%,” Anastasio explains. That means you can get an LTV ratio of 96.5%.
But Anastasio says that “for a cash-out refi, lenders will very rarely go above 90%, and it may be even lower. Reasonably, expect 80%.”
She’s right on the money there. In 2019, the Federal Housing Administration made moves to reduce risk on cash-out refis, lowering their maximum LTV from 85% to 80%.
In short, to qualify for a cash-out refinance, you’ll need everything you usually need for a mortgage (steady cash flow, good credit, etc.), along with at least 20% equity in your home. For example, if your home’s worth $300,000, you’ll need $60,000 in equity.
Now comes the fun part: cash-out refinancing tax implications.
Is A Cash-Out Refinance Tax-Deductible?
Is a cash-out refinance taxable? Or, more specifically, are you subject to income taxes? The short answer is ‘no.’ “Taking cash out isn’t income, it’s a loan,” Anastasio says. “So, from an income standpoint, that’s not taxable.”
You won’t pay more in taxes just because you choose a cash-out refinance. But you might lose certain tax perks (namely, deductions) depending on how you use the cash.
“Under the recent changes in the tax law, if you’re using the cash-out for personal reasons — like to pay off debt — you need to be aware that you can no longer write off that interest,” says Lisa Greene-Lewis, Certified Public Accountant and Tax Expert at TurboTax.
After December 2017, you can deduct your mortgage interest only on the part of the mortgage that’s used to “buy, build, or substantially improve your home.” So if you use your cash-out for something else, like paying off credit card debt or taking your dream vacation, don’t try to deduct the interest.
“Your cash-out refi has to be used to improve your main home in order for you to deduct your interest,” Greene-Lewis says.
And just because you consider something an upgrade doesn’t mean it technically counts as one, either. “It’s got to be what’s called a capital-home improvement, like adding a bedroom, a swimming pool, or a new roof — something that’s going to add value to the home,” Hogan explains. “It can’t be a repair, like replacing an HVAC system or fixing a broken window.”
There are additional cash-out refinancing tax implications to consider, too.
Mortgage Interest Deduction Maximum
It’s helpful to know that there’s a ceiling on the mortgage interest deduction you can take. “As of the start of the 2018 tax season, the interest you can write off has to be based on a loan amount of up to $750,000,” Greene-Lewis says. You can refinance for a larger mortgage, certainly, but you’ll only be able to take a deduction on the interest of the loan amount up to $750,000.
If you buy mortgage points during your refinance, you might get a tax deduction there. “Discount points are where you buy down your rate from your lender. You’re prepaying some interest to get a cheaper rate. A portion of your discount points on your refi can be deducted — generally not on your first year, but in years after,” Hogan explains.
According to Publication 936 on the IRS website, mortgage points usually aren’t fully deductible in the first year after you get your mortgage. But if you use the cash-out refinance portion of your new mortgage to improve your home and you meet all six “tests” outlined under “Deduction Allowed in Year Paid” on page 7, you might be able to fully deduct the portion of your points that went toward the home improvement.
Property Taxes and Local Taxes
Additionally, Anastasio reminds us that if you improve your property and it gets reappraised for a higher value, you could end up paying more in property taxes. “It’s really important to look at your local laws,” she says. “There may be other types of taxes that apply, like recordation taxes, which are basically recording fees for your municipality or mortgage registration taxes.”
To avoid getting hit with surprise cash-out refinance taxes, Hogan has good advice. “I recommend people sit down and talk with a tax professional to walk through their specific situation,” he says.
Key Takeaways: Cash-Out Refinancing Tax Implications
You don’t need to worry about getting slammed with cash-out refinance taxes, but you might lose some deductions if you don’t use the cash for capital improvements to your home. And there might be specific local taxes to consider, too. “Make sure you’re working with a lender that’s very familiar with your region and ask specifically if there are any unique, local taxes that could apply to you,” Anastasio says.
She also reminds us that just because you get approved to take out a certain amount of cash doesn’t mean you need to accept it all. And don’t forget to look down the road a few years. “How much equity will be there for you when you want to sell?,” she asks, adding, “We don’t have to take everything the bank offers us. Only take out what you need. Reflect on your goals and what you’re trying to accomplish by going through this process.”