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Understanding FHA Cash-Out Refinance Loans

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Refinancing a loan insured by the Federal Housing Administration (FHA) can help you reduce your mortgage rate and monthly payment amount. Fortunately, there’s an FHA refinance program that can help you achieve all these goals and tap equity: an FHA cash-out refinance.

What is an FHA cash-out refinance?

An FHA cash-out refinance is a mortgage that is insured by the FHA. This type of FHA loan allows you to take out a new mortgage and pay off your existing loan and borrow against your equity.

A cash-out refinance has a larger loan amount than your existing loan, and allows you to take out the difference between both loan amounts in cash.

There are several uses for an FHA cash-out refinance, including:

  • Funding a home improvement project
  • Starting a business
  • Covering higher education expenses
  • Consolidating high-interest debt

If you’re interested in borrowing against your home equity, use a cash-out refinance calculator to determine how much you might be able to borrow.

FHA cash-out refinance guidelines

To qualify for an FHA cash-out refinance, you must:
  • Show that the property is your primary residence.
  • Have lived in the property for at least a year.
  • Have made on-time payments each month for the last 12 months.
  • Have a maximum 80% LTV ratio.
  • Have a minimum 500 credit score.
  • Have a maximum 50% DTI ratio.
  • Borrow below your local FHA loan limits.

 

You’ll need to meet the following eligibility guidelines to qualify for an FHA cash-out refinance:

  • Refinancing the loan for your principal residence. You’ll need to provide proof, such as utility bills, showing that the property is your primary residence.
  • Lived in the home for 12 months or longer. You’re required to have lived in your primary residence for the last year.
  • Must have made on-time mortgage payments in each of the last 12 months. Payments must have been made within the month due. If you own your home free and clear, you may qualify for a cash-out transaction.
  • An LTV ratio of 80% or less. As of Sept. 1, 2019, borrowers are required to have a maximum 80% loan-to-value (LTV) ratio. An LTV ratio is the percentage of your home’s value that is financed by the mortgage. Previously, FHA cash-out refinances allowed an 85% LTV ratio maximum, which gave borrowers access to more of their equity.
  • A minimum credit score of 500. FHA’s standard minimum credit score is 580, but if you have at least 10% equity, your credit score can be as low as 500.  Remember that an FHA cash-out refinance LTV ratio can’t exceed 80%, meaning you’ll need at least 20% equity for this specific loan.
  • A DTI ratio of 50% or less. Your debt-to-income ratio, or the percentage of your gross monthly income used to repay debt (including your mortgage) can’t exceed 50%.
  • Loan amount must stay within FHA loan limits. There are FHA refinance loan limits, which are typically set at 65% of the national conforming loan limits for single-family homes in most U.S. counties. Use the FHA’s loan limit search tool to find your local loan limit.

Pros and cons of an FHA cash-out refi

An FHA cash-out refinance comes with several benefits and drawbacks. Keep them in mind as you consider this mortgage.

Pros

  • Lenient credit and DTI requirements. You don’t need an excellent or good credit score to qualify for an FHA cash-out refinance, and also there’s some wiggle room with DTI ratio requirements.
  • Don’t need an FHA loan to qualify. You can still qualify for an FHA cash-out refi if you have a conventional mortgage.
  • Use your equity for virtually any purpose. Having the flexibility to use the cash you take out of your home for anything from a kitchen upgrade to debt consolidation makes this type of refinance an attractive option.
  • Can deduct mortgage interest at tax time. You can use the mortgage interest deduction on 100% of the interest paid on the new loan amount, but only if you’re making improvements to your home.

Cons

  • Pay for mortgage insurance. FHA loans require mortgage insurance premiums. There’s an upfront premium paid at closing and an annual premium that’s divided into 12 installments and added to your monthly mortgage payment.
  • Non-occupant co-borrowers aren’t allowed. You won’t be able to rely on a loved one who doesn’t share your residence for their credit or income to help you qualify.
  • Reduction in your available equity. A cash-out refinance reduces the amount of equity you’ve built, putting you at risk of being underwater on your mortgage if home values plummet.
  • Lower loan limits. FHA loan limits are lower than those for conventional loans. If you have a significant amount of equity in your home, the higher loan amount you borrow to cash out your equity could push you close to or over your local loan limit.

Alternatives to an FHA cash-out refinance

If you’re not quite sold on an FHA cash-out refinance, here are some other financing options.

  • Conventional cash-out refinance. If you have at least a 620 credit score and DTI ratio below 50%, you might benefit from a conventional cash-out refi. You might come across a few lenders that allow an 85% LTV ratio, but generally the 80% LTV maximum applies.
  • Home equity loan. As the name suggests, a home equity loan allows you to borrow a loan against your equity. The money is disbursed in a lump sum and you make installment payments toward the loan principal and interest each month until it’s paid off.
  • HELOC. A home equity line of credit, or HELOC, works similar to a credit card. You’re still borrowing against your equity, but it’s a revolving credit line and not a loan. You only pay interest on what you borrow. Both a home equity loan and HELOC use your home as collateral to secure the loan so if you don’t make payments on time, you could lose your home to foreclosure.
  • Rate-and-term refinance. While you won’t borrow against your equity with a rate-and-term or “no cash-out” refinance, you can get a mortgage with better overall terms, which could keep extra money in your pocket each month.
  • Personal loan. With higher interest rates than most mortgage loans, a personal loan can be a more expensive way to borrow money. However, it might be a better option, especially if you don’t have enough home equity to borrow against or can repay the loan quickly.

FHA cash-out refinance FAQs

Will I pay closing costs on an FHA cash-out refinance?

Because an FHA cash-out refi involves taking out a brand-new mortgage on your home, you will pay refinance closing costs, which typically include lender fees and third party charges, such as an appraisal, inspection and title search. Closing costs can range from 2% to 6% of your loan amount, depending on your loan’s size.

I made a late mortgage payment once over the last year. Do I still qualify for an FHA cash-out refi?

FHA cash-out refinance guidelines require borrowers to make payments within the month they are due, which means a past-due payment can keep you from qualifying. Still, it doesn’t hurt to speak with a lender to understand your options.

What happened to the 85% maximum LTV requirement?

In August 2019, the FHA announced it was reducing the maximum LTV ratio allowed on cash-out refinances from 85% to 80%. This was done to align with guidelines from Fannie Mae and Freddie Mac — the two major mortgage agencies that buy and sell loans — and applies to all FHA cash-out refinances originated on or after Sept. 1, 2019.

Can I deduct the mortgage interest paid on my cash-out refinance?

You can claim the mortgage interest deduction on a cash-out refinance if the cash was used to improve your home. Otherwise, the interest paid on the cash-out amount isn’t deductible. You can still deduct the interest paid on the original loan amount, though.

How do I get rid of mortgage insurance premiums?

To get rid of mortgage insurance premiums (MIP) on an FHA cash-out refinance, you’ll need to later refinance into a conventional loan. Just be sure you maintain an LTV ratio below 80% to avoid private mortgage insurance. Your other option is to keep paying MIP until you’ve had your FHA cash-out refi loan for 11 years, after which point it will be removed.

 

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