What Is A Limited Cash-Out Refinance And How Does It Work?

While being a homeowner may never be an inexpensive prospect, tools exist to help borrowers afford their home. If you’re trying to make ends meet and have a high interest rate on your mortgage, a limited cash-out refinance can provide some cash relief and help you save money on interest or your loan term.

A limited cash-out refinance replaces your existing mortgage with a new mortgage with better terms. The new loan is often a higher amount to help cover closing costs.

Fannie Mae governs the functions of cash-out refinances. With a limited cash-out refinance, you can pocket $2,000 or 2% of the new loan balance, whichever is less. However, the new loan balance will be higher than the original because of the funds disbursed and any closing costs not paid upfront.

As the name implies, a no cash-out refinance does not allow the borrower to walk away from closing a new loan with extra cash. Instead, it is a rate and term refinance, meaning the borrower refinanced to get a better interest rate, loan term, or work with a lender they prefer.

Additionally, you don’t have to roll closing costs into the new balance with a no cash-out refinance. Therefore, a borrower can get a new loan with an identical amount or lower amount than before.

A cash-out refinance does not have the limitations of the other refinancing options listed above. A borrower with a large chunk of their mortgage paid off could receive tens of thousands of dollars from a cash-out refinance. The maximum a cash-out refinance could provide is usually 80% of your home’s value.

This option differs from the other two types of mortgage refinances. No cash-out refinances give the borrower better terms and rates but no direct money. Limited cash-out refinances also allow borrowers to get better terms and provide the borrower with a bit of money, typically $2,000.

Limited Cash-Out Refinance Vs. Other Cash-Out Refi Types

There are plenty of refinancing options available for borrowers in different situations. However, refinancing is not a one-size-fits-all solution, so it pays to research before you get yourself into a refi that doesn’t work for you.

• FHA cash-out refinances are advantageous for homeowners with lower credit scores. Because the FHA insures the loan, it will have a reduced interest rate, but the borrower must pay mortgage insurance for 11 years.
• A VA cash-out refinance helps veterans, active-duty military, Reserve and National Guard members, and surviving spouses. Borrowers can receive up to 100% of their home’s value to settle debts, meet other expenses, or change their mortgage into a VA loan, which usually has better conditions than other loans.
• A cash-in refinance means the borrower uses a sizable amount of cash to put a dent in their mortgage. As a result, the borrower will increase their equity, and homeowners with an underwater mortgage will find cash-in refinances to often be their best option.
• FHA Streamline refinances provide borrowers with a swift method of refinancing, but you must pay closing costs and mortgage insurance.
• VA Streamline refinances allow military members and surviving spouses to rapidly secure a new loan that provides an instant improvement, such as a smaller monthly payment or reduced interest rate.
• A no-closing-cost refinance has closing costs put into a new loan. Borrowers could have a higher monthly payment, steeper interest rate, or both.
• Short refinances can help borrowers who have defaulted on their mortgage. Borrowers receive a decreased mortgage balance and monthly payment. As a result, the homeowner gets to stay in their home, and the lender does not have to take the larger financial hit that a foreclosure or short sale would have inflicted.

You will need to include closing costs when you are planning to refinance. Typically, closing costs are about 2% – 6% of the balance on your existing mortgage. You won’t need to pay the money up front, as it can be added to your new loan balance. However, your loan balance will increase because of closing costs, causing you to pay more over time in interest.

At the end of the process, you’ll have a new mortgage comprising closing costs, escrow expenses, outstanding property taxes, and the original mortgage payoff amount.

All lenders have refinance requirements for borrowers who want to restructure their mortgage. Generally, the requirements for a limited cash-out refinance are more lenient than a traditional cash-out refinance. Here are three main factors Fannie Mae uses to determine eligibility for a limited cash-out refinance.

• Loan-to-value ratio (LTV): To refinance, you need a certain amount of equity in your home. In other words, if you haven’t paid off enough of your existing mortgage, you might not be eligible for a refinance. Conventional loans usually require an LTV of 97% or lower, meaning the loan size will be 97% of your home’s appraised value or less. Therefore, you most likely won’t have to pay down a significant portion of your mortgage to qualify for a limited cash-out refinance.

• Debt-to-income ratio (DTI): Lenders calculate this figure by dividing the sum of your minimum monthly debt payments by your monthly pretax income. Debts such as your mortgage payment, property taxes, homeowners insurance, student loans, and credit card debt contribute to your DTI. The ratio tells Fannie Mae if a borrower can afford the monthly payment of the new mortgage.

• Credit score: The better your credit score, the easier it is to secure a new loan and obtain a better interest rate. Borrowers should aim for a credit score of 620 or higher to be eligible for refinancing.

As with any financial tool, there are advantages and disadvantages to using a limited cash-out refinance, as outlined below.

Pros

• Closing costs can go into the new loan amount and don’t need to be paid upfront.
• The borrower comes out of the process with $2,000 to use as they wish.
• To be eligible, little equity is needed; buyers with almost no equity can qualify.
• Borrowers may be able to secure a better interest rate or loan term.

Cons

• Borrowers come out of the process with a higher loan amount.
• The maximum return for this transaction is $2,000, so a traditional cash-out refinance might be better for borrowers with more equity and heftier expenses.
• The refinance cannot go through if your home is for sale.

Let’s say a homeowner has $150,000 left on their mortgage for their home that appraises for $180,000. After communicating with Fannie Mae, the homeowner learns they can refinance the home and lower their interest rate. The homeowner also has a minor home improvement project that will cost about $2,000 but is having trouble finding the money for it.

In this case, a limited cash-out refinance is a better option than a no cash-out refinance because the homeowner is fielding a $2,000 expense. A limited cash-out refinance allows the borrower to kill two birds with one stone, securing a better interest rate and providing a bit of cash to improve the house.

In addition, since Fannie Mae will incorporate closing costs into the new loan amount, the borrower doesn’t have to pay for the refinance, instead pocketing $2,000 and paying a lower interest rate. The borrower does take on a higher loan balance but has decided that the pros outweigh the cons because of the interest rate and immediate cash benefit.

A limited cash-out refinance makes the most sense for a borrower with a low amount of equity in their home and a pressing need for around $2,000. Since Fannie Mae’s requirements are more forgiving than other refinancing options, limited cash-out refinances are accessible to more borrowers. If you’re considering a limited cash-out refinance, use our refinance calculator to determine if a refinance is right for you.