As long as you have enough equity to pay off the existing mortgage and take out the amount of cash you want, you can do a cash out refinance on the property and use the proceeds to renovate your home. There typically are no restrictions on how you use the proceeds from a cash out refinance and paying for improvements to your primary residence is certainly permitted. There are a couple of points to keep in mind, however, if you apply for a cash out refinance.
First, the mortgage rate and fees for a cash out refinance are usually .250% to .750% higher than for a rate and term refinance when the borrower receives no loan proceeds. Additionally, the rate for a mortgage on a second home is moderately higher than the rate for a mortgage on your primary residence.
Review How a Cash Out Refinance Works
Furthermore, if the property is an investment or rental property, the mortgage rate is even higher. The higher your mortgage rate, the higher your monthly payment. We highlight this point to illustrate that it may be more cost-effective to access the equity in your primary residence as opposed to your second home.
The table below shows mortgage refinance terms for leading lenders in your area. We recommend that you contact multiple lenders to find the lowest refinance rate and closing fees. Shopping for your mortgage is the best way to save money when you refinance.
Another point to consider is that the maximum loan-to-value (LTV) ratio for a cash out refinance is lower than for a purchase mortgage or standard refinance. Below we outline the maximum LTV ratio by mortgage and property type. We include the LTV ratio for a rate and term refinance for comparison.
One unit primary residence rate and term refinance (fixed rate mortgage): 97% LTV ratio
One unit primary residence cash out refinance: 80% LTV ratio
One unit second home cash out refinance: 75% LTV ratio
One unit investment property cash out refinance: 75% LTV ratio
Two-to-four unit investment property cash out refinance: 70% LTV ratio
Please note the FHA cash out refinance program permits a maximum LTV ratio of 80% for one-to-four unit properties (as long as you occupy one of the units) but second homes and investment properties are not eligible for the program.
The LTV ratios for a cash out refinance, as outlined above, put a cap on what size mortgage you can qualify for and potentially limit the proceeds you can take out when you refinance. You need to make sure that your property is valued highly enough to both pay off your current mortgage and provide the loan proceeds you want without exceeding the maximum LTV ratio.
For example, if you want to do a cash out refinance on a second home valued at $400,000 that has a $300,000 current mortgage balance, you would reach the maximum 75% LTV ratio ($300,000 / $400,000 = 75%) without taking any cash out.
This is why we recommend that you understand your estimated property value to make sure that you have enough equity before you apply for a cash out refinance. The last thing you want to do is apply for a mortgage only to find out later that you cannot accomplish your financing objectives. You may also realize that accessing the equity your primary residence is a better financing alternative.
One financing alternative you should consider instead of a cash out refinance is a home equity loan or line of credit (HELOC). Both a home equity loan or HELOC may enable you to borrow the loan proceeds you want for your home renovations but because they are smaller, the closing costs are lower than a refinance. Plus, a smaller loan reduces your total interest expense compared to a refinance.
Review Should You Refinance or Get a Home Equity Loan?
Additionally, depending on the combined loan-to-value (CLTV) ratio permitted by the lender, you may have more financing capacity with a home equity loan or HELOC as compared to a refinance. CLTV ratio is the ratio of all the mortgages on a property, including a home equity loan or HELOC, relative to the fair market value of the property. For example, a home equity loan lender may allow a CTLV ratio of 85% to 90%, which is significantly higher than the LTV ratio allowed for a cash out refinance.
The table below shows home equity loan rates and fees for top-rated lenders. We recommend that you shop multiple lenders to select the loan that best meets your financing needs.
The final point to consider when you evaluate your financing options is the mortgage interest tax deduction. Interest expense on a mortgage or home equity loan (up to $750,000 in combined loans) on your primary residence or second home is tax deductible as long as the loan is used to buy, build or improve the property that secures the mortgage.
Review How the Mortgage Tax Deduction Works
This means that if you use the proceeds from a cash out refinance or home equity loan on your second home to improve your primary residence you may not be able to deduct all of your interest expense. We advise you to contact a tax specialist or an accountant to understand how the mortgage tax deduction applies to you based on your type of loan and use of proceeds. Understanding your mortgage tax benefit should be the final input to help you determine the financing option that is right for you.
"B2-1.3-03, Cash-Out Refinance Transactions." Selling Guide: Fannie Mae Single Family. Fannie Mae, July 3 2019. Web.
"Interest on Home Equity Loans Often Still Deductible Under New Law." IRS. Internal Revenue Service, February 21 2018. Web.