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Mortgage Basics

Do I Have to Pay Taxes on a Cash-Out Refinance?

A cash-out refinance loan essentially turns some of the home equity you've built up into cash. It does this by refinancing your remaining mortgage balance to a new, larger loan and giving you the difference. The new loan amount is based on how much equity you have in your home (the difference between what your home is worth and what remains to be paid on your mortgage). You can use the cash payment you receive for almost anything—a kitchen remodeling project or your child's college expenses, for example.

So, once you have that cash in hand, are you required to pay taxes on it? Fortunately, the answer is no. You do not have to pay income taxes on the money you get through a cash-out refinance. Here's what you need to know about a cash-out refinance loan, including how to qualify, what the tax implications are and the risks of getting one.

What Is Cash-Out Refinancing?

Cash-out refinancing is a way to tap the progress you've made in paying off your home loan without doing something as drastic as selling your home. It replaces your existing mortgage with a new home loan that exceeds the amount that you owe on your house and gives you the difference.

Here's an example:

Your home is valued at $300,000.
Your mortgage balance is $175,000.
Your equity is the difference between those amounts, or $125,000.
Your new loan will likely be limited to 80% of the home's value, or $240,000.

The maximum amount you can get in cash is the difference between your new loan amount and your previous mortgage balance, or $65,000 in this example.

You can receive this cash in the form of a cash payment that you can spend on an array of needs, such as:

  • Tackling a home improvement project
  • Wiping out high-interest debt
  • Funding a retirement account
  • Paying college tuition
  • Buying an investment property
  • Purchasing a second home

Tax Implications of Cash-Out Refinancing

The cash you collect from a cash-out refinancing isn't considered income. Therefore, you don't need to pay taxes on that cash. Instead of being considered income, a cash-out refinance is simply a loan.

Depending on how you spend the money from a cash-out refinance, you might even be eligible for a tax deduction. For example, you're allowed to deduct the interest on the original loan if money from the cash-out refinance goes toward permanent improvements that boost the value of your home. Those improvements could be:

  1. Putting in a swimming pool.
  2. Adding a bedroom.
  3. Installing a home security system.
  4. Upgrading the heating and air conditioning system.
  5. Replacing outdated windows.

You also can deduct all of the costs associated with buying points to lower the interest rate of the cash-out refinance.

However, you cannot claim any tax deductions if you spend the money from the cash-out refinance on:

  • Repairs, repainting and other work that doesn't increase the home's value.
  • Consolidating debt, going on a cruise or anything else that's not tied to a home improvement project.

How Do You Qualify for a Cash-Out Refinance Loan?

To get a cash-out refinance loan, you'll need to have enough equity in your home. In most cases, a lender will consider you for a cash-out refinance if you have equity of at least 20%.

To figure out whether you qualify, a lender will look at the loan-to-value ratio. This ratio is calculated by dividing the amount you owe on your mortgage by the value of your home. So, if the mortgage balance is $160,000 and the value of your home is $200,000, the loan-to-value ratio is 80%. An 80% ratio translates into 20% equity, which would meet the equity requirements of most cash-out lenders.

What Else Might a Lender Consider?

  1. Your income and assets: How much money do you earn, and how much money do you have in bank accounts and retirement accounts? In addition, do you own property other than your home?
  2. Your debts: What's your total debt, including credit cards, student loans and personal loans? A lender will also take into account your debt-to-income ratio. To come up with this ratio, divide your monthly debt obligations (including mortgage, utilities and credit cards) by your income before any taxes and deductions are taken out. This ratio helps a lender determine your ability to manage debt, and the amount and interest rate of a loan.
  3. Your credit score and credit history: Someone with poor or bad credit can qualify for a cash-out refinance. Although home equity lines of credit (HELOCs) and home equity loans require a FICO® Score of at least 660 to 700, a lender might approve a cash-out loan for someone with a lower score. A lender also will examine your credit history when deciding whether to approve your application for a cash-out refinance loan.

The Risks of Cash-Out Refinancing

While cash-out refinancing can free up access to thousands of dollars, it also comes with potential risks.

Foreclosure

Just as with a traditional mortgage, your home serves as collateral for a cash-out refinance. So if you're unable to make payments, the lender might foreclose on your home. Keep this in mind if you intend to use the money from the cash-out loan (which is secured by your home) to pay off credit card debt (which is not secured by any collateral). Credit card debt is a serious matter, but there are other ways to handle it that don't involve putting your home on the line.

Different Terms

Your cash-out refinance loan will carry new terms, such as various fees and a different interest rate. It's important to know those terms so you don't run into unpleasant financial surprises down the road.

Closing Costs

Closing costs typically accompany all refinance loans, including a cash-out refinancing. These costs normally range from 2% to 5% of the mortgage amount. At those rates, the closing costs would total $3,600 to $9,000 for a $180,000 mortgage.

Succumbing to Bad Habits

Let's say you apply money from the cash-out refinance to erase credit card debt. While the cash can fix your short-term debt problem, it might simply be a bandage that hides a longer-term wound. You could be jeopardizing ownership of your home if this money only fixes a small issue that's part of broader monetary troubles, such as spending that regularly exceeds your household budget. If you find yourself in a situation like this, it might be wise to seek help from a nonprofit credit counselor.

Alternatives to Cash-Out Refinancing

If you'd rather avoid a cash-out refinance loan, there are several borrowing alternatives you can explore.

Personal Loans

A personal loan lets you borrow a fixed amount of money and pay it off over a fixed term. And because the interest rate of the loan is also typically fixed, your monthly payments will be roughly the same for the life of the loan. Unlike a cash-out refinance, however, most personal loans are unsecured, meaning you don't have to offer collateral (like a car or house).

Taking out a personal loan gives you a good amount of freedom in terms of how you spend the borrowed money. For example, you might want to consolidate high-interest credit card debt, buy new furniture for the living room, pay for a European vacation, or cover unexpected medical bills.

Home Equity Line of Credit (HELOC)

With a HELOC, can you borrow between 60% and 85% of the current assessed value of your home, minus what you still owe on the mortgage. As with a credit card, a HELOC is a revolving line of credit that generally has variable interest rates.

A HELOC comes with a credit limit that's based on and secured by the amount of equity you have in your home. You can tap into this line of credit whenever you like and for whatever reason, as long as you don't exceed the credit limit. You make payments only when you borrow against the line of credit. Eventually, after a certain time has passed (10 years is common), your HELOC will enter a repayment period and any remaining balance will be converted to an installment loan you'll pay back over a set term.

A HELOC isn't the same as a home equity loan, however. A home equity loan is always an installment loan, like an auto loan or student loan, instead of a revolving line of credit. An installment loan comes with a set monthly payment and interest rate, and it's repaid over a set number of months or years.

Refinancing Your First Mortgage

When you refinance your first mortgage, you can opt to pay off the old loan and replace it with a new one for the same amount. By contrast, the amount of a cash-out refinance loan exceeds the amount you owe on your home.

The primary goal of a conventional refinancing loan, known as a rate-and-term refinance, is to score a lower interest rate and reduce your monthly payments or to change the term of the loan (such as going from 30 years to 15 years). Although it's a complicated process that might require the help of a professional, it's possible to squeeze some extra cash out of a conventional refinance without it being designated a cash-out refinance.

A traditional mortgage refinance typically requires you to have at least 20% equity in your home.

The Bottom Line

A cash-out refinance can supply some much-needed money by tapping into the home equity you've built up. One advantage: You won't need to pay taxes on the cash because it's not classified as income. This type of refinancing can be especially beneficial when you're taking on a major home improvement project, since you might qualify for a tax deduction if the project increases the value of your home. As always, though, you should weigh your financial situation and your borrowing options to figure out whether a cash-out refinance is the most appropriate source of money.