What is a limited cash-out refinance and how does it work?

Looking for a lower mortgage interest rate? Want a bit of extra cash to pay down credit card debt or finance a small home-improvement project? With a limited cash-out refinance, you might reach two goals at once: Nabbing a lower mortgage rate and padding your savings or covering a smaller expense with a bit of extra cash.

What is a limited cash-out refinance?

With a limited cash-out refinance, you’ll replace your existing mortgage with a new one that preferably comes with a lower interest rate.

This new loan might be for a slightly higher amount than your current mortgage. That’s because many homeowners include their closings costs – which can run from 3% to 6% of the amount you are refinancing – in their mortgage. And with a limited cash-out refinance, you might also take out a bit of extra cash with the transaction, a cash amount that will also add to your loan’s balance.

A limited cash-out refinance differs from a traditional refinance because you’ll receive a small amount of cash once it closes. You can spend this cash – or save it – however you’d like, though you can’t use it to pay off a home equity loan or home equity line of credit. With a limited cash-out refinance, you can get up to $2,000 in cash or up to 2% of the new loan balance, whichever is less.

To do this, you’ll refinance for more than what you owe on your current mortgage. Say you are refinancing $200,000. You’d qualify for $2,000 in cash back because 2% of $200,000 comes out to $4,000, which is more than the $2,000 maximum of a limited cash-out refinance.

If you aren’t rolling your closing costs in your loan, your new loan amount would be $202,000, because of the extra cash that you receive, which you would pay back with regular monthly payments with interest.

Ineligible transactions 

There are times when you’re unable to apply for a limited cash-out refinance.

According to Fannie Mae, you can't apply for a limited cash-out refinance if there is no outstanding first lien on your home. A first lien is your primary mortgage, the one you took out to finance the purchase of your home. If there is no first lien, it means that you've already fully paid off your primary mortgage.

You can't use a limited cash-out refinance to pay off a home equity loan or line of credit that was not used to purchase your home.

Fannie Mae also says that you can't use a limited cash-out refinance to combine your first mortgage and a subordinate loan such as a home equity loan or line of credit into one new mortgage.

Limited cash-out refinance vs. no cash-out refinance

If you don’t want to take away any cash after a refinance, you can also apply for a no cash-out refinance. With this type of refinance, you’ll swap your current mortgage with a new loan that comes with a new interest rate or term.

Usually, the goal is to exchange your current mortgage for one with a lower interest rate, a move that will also reduce your monthly payment.

You might also want to change your loan’s term. Borrowers with a 30-year term might refinance to a mortgage with a shorter 15-year term to save on the amount of interest they pay over time. Those with a 15-year term might want to refinance to a 30-year mortgage to lower their monthly payment.

Borrowers can choose to roll their closing costs into their new loan. They might also choose to pay them upfront. If they pay their closing costs upfront, the amount that they borrow will be lower.

Limited cash-out refinance vs. cash-out refinance

If you want more cash, you can apply for a cash-out refinance. In this type of refinance, you can receive a far greater amount of cash than $2,000.

With a cash-out refinance, you’ll again refinance for more than what you owe. Say you owe $200,000 on your mortgage. You might refinance to a new mortgage of $280,000 and take the extra $80,000 in cash. You’ll have to pay back the full $280,000 that you borrow, but you can use that $80,000 in cash however you’d like.

The amount of cash that you receive from a cash-out refinance depends on your home’s value and how much you owe on your current mortgage.

Most lenders allow you to borrow up to 80% of your home's current value with a traditional cash-out refinance. Say you have a home worth $300,000. Most lenders would allow you to take out a new mortgage of up to $240,000, or 80% of your home's value. If you owe $150,000 on your current mortgage, you could receive up to $90,000 cash back, or $240,000 minus $150,000.

Limited cash-out refinance vs. other cash-out refi types

You have plenty of refinancing options if you’re ready to swap your mortgage for a new loan. Having so many choices is good. But it’s important to do the research on how these programs work to make sure you find the right option for your financial situation.

• FHA cash-out refinance: This type of refinance is insured by the Federal Housing Administration (FHA). On the plus side, you might qualify for a lower interest rate than if you were refinancing to a conventional mortgage. On the downside, you’ll pay for mortgage insurance for the life of your new loan.
• VA cash-out refinance: The Department of Veterans Affairs (VA) insures cash-out refinances for qualifying veterans, active-duty members of the military, Reserve/National Guard members, and surviving spouses who have not remarried. Borrowers can receive up to 100% of their home’s value to consolidate higher-interest-rate debt, meet other expenses, or change their mortgage into a VA loan.
• Cash-in refinance: This type of refinance allows you to make a lump sum payment toward your home loan during the refinance to increase the equity in your home. This will leave you with a smaller principal balance to pay back. A cash-in refinance might be a smart move if you have an underwater mortgage – a mortgage in which you owe more than what your home is worth – or you want to qualify for a lower interest rate now that you have more equity in your home.
• FHA Streamline refinances: This option is a swift method of refinancing that allows you to lower your interest rate and reduce your monthly payment while providing less paperwork to close your transaction. To qualify for this option, you’ll need to already be paying off an FHA loan and you’ll need to refinance to another FHA-insured mortgage. You’ll also need to pay mortgage insurance on your new loan.
• VA Streamline refinances: These refinances allow military members, veterans and surviving spouses to rapidly secure a new VA loan, again while providing less paperwork. Your new loan will need to result in a financial benefit, such as a smaller monthly payment or lower interest rate. These loans are also known as VA interest rate reduction loans.
• No closing-cost refinance: With this type of refinance, no closing costs are required up front or at closing. Instead, you’ll roll the closing costs into your new loan amount. With a no-closing-cost refinance you’ll either pay back a higher principal balance or pay a higher interest rate to cover the closing costs you won’t pay up front. The advantage? You won’t have to come up with a big chunk of cash to close your refinance.
• Short refinances: In a short refinance, your lender agrees to refinance your existing mortgage to a new loan for less than what you currently owe. This also results in a lower monthly payment. Not all lenders offer short refinances. The goal, though, is to help borrowers stay in their home if they are struggling to make their mortgage payments.

How much does a limited cash-out refinance cost?

Refinancing isn’t free. The same holds true for a limited cash-out refinance. How much you pay in closing costs will vary, but you can expect to pay from 2% to 6% of the loan balance that you are refinancing.

If you’re refinancing a loan with a balance of $200,000, you can expect to pay from $4,000 to $12,000 in closing costs.

You can choose to pay closing costs up front or roll them into your new mortgage’s balance. If you choose the latter option, you’ll end up with a higher loan balance. This means you’ll also pay more in interest over time.

Requirements for a limited cash-out refinance

You’ll have to meet certain refinance requirements if you want to swap your existing mortgage for a new one. These requirements will vary by lender, but most lenders will look at such factors as your loan-to-value ratio, credit score and debt-to-income ratio.

Here are three main factors Fannie Mae uses to determine the eligibility of homeowners applying for a limited cash-out refinance:

Loan-to-value ratio (LTV)

You need a certain amount of equity in your home to qualify for any refinance, including a limited cash-out refi. If you haven’t paid off enough of your existing mortgage, you might not be eligible for a refinance.

Fannie Mae says that your combined loan-to-value ratio must be 97% or lower if you want to qualify for a limited cash-out refinance. This means that the combination of all your mortgage loans – including your primary mortgage and any home equity loans or home equity lines of credit – must equal no more than 97% of your home’s appraised value. You’ll need 3% equity, then, to qualify for a limited cash-out refinance.

Depending on the size of your down payment and how many mortgage payments you’ve made before you apply for a refinance, you’ll likely hit this LTV quickly in the life of your mortgage, especially if your home’s value increases.

Debt-to-income ratio (DTI)

Lenders want to make sure that you can afford your new monthly mortgage payment after your refinance. To do this, they’ll calculate your debt-to-income ratio, a measure of how much of your gross monthly income that your recurring monthly expenses consume.

Lenders consider monthly payments including your estimated new mortgage payment, minimum monthly credit card payment and student, auto and personal loan payments when calculating your DTI. They also consider alimony and child-support payments that you must make each month. To determine your DTI, they’ll divide your monthly payments by your gross monthly income and multiply that result by 100.

It varies, but most lenders prefer that your DTI be no higher than 36%.

Credit score

The higher your three-digit FICO^® credit score, the easier it is to qualify for a new mortgage at a lower interest rate. Most lenders consider FICO^® scores of 740 – 799 to be “very good” and those of 800 or higher to be “exceptional.” If you want the lowest interest rate on your new mortgage, aim for a score in those ranges.

Documentation requirements

You’ll need to provide your lender with several documents when you apply for a limited cash-out refinance.

To prove you earn enough income to cover your new loan payment, you’ll usually need to provide copies of your two most recent paycheck stubs and your last 2 months of bank account statements. Lenders will usually want to see copies of your last 2 years of income-tax returns and last 2 years of W-2 forms.

You might also need to provide your lender with a copy of the settlement statement from the purchase of your property.

Handling subordinate financing

But what if you also have a subordinate loan on your home, such as a home equity loan or line of credit?

After you close your limited cash-out refinance, these second loans must remain subordinate to your new primary mortgage.

This means that if you stop making your mortgage payments and the holder of your primary mortgage starts the foreclosure process against you, the lender of your primary mortgage is paid first and the lenders that provided your subordinate loans are only paid after, if there are any funds left over.

Pros and cons of a limited cash-out refinance

There are pos and cons to consider when deciding whether a limited cash-out refinance is right for you.

Pros

• You can roll the closing costs of your refinance into your new loan amount. If you do, you won’t need to come up with the cash to pay these costs up front.
• You can receive up to $2,000 in cash to use as you wish.
• You won’t need to build much equity in your home to qualify. Homeowners with almost no equity can qualify for a limited cash-out refinance.
• Your new mortgage might come with a lower interest rate or a loan term that works better for you.

Cons

• Because you’re receiving cash that you must also pay back, you’ll need to pay back a slightly higher loan amount.
• The maximum cash-out for this transaction is $2,000. A traditional cash-out refinance might be better for borrowers with more equity or those who need money to cover larger expenses.
• You can’t take out a limited cash-out refinance if your home is for sale.

What can I spend the money from my cash-out refinance on?

You can spend the money you receive from a limited cash-out refinance on whatever you’d like. Because you’re not receiving an especially large sum of money – just a maximum of $2,000 – you’ll need to spend it on smaller purchases.

You might pay down a high-interest-rate credit card balance, essentially swapping debt with a higher rate for new debt with a far lower one. You might spend your money on a smaller home repair, such as adding shingles to your home’s windows, boosting your home’s landscaping or replacing an aging dishwasher, stove, or refrigerator.

When to choose a limited cash-out refinance

Let’s say a homeowner has $150,000 left on their mortgage for their home that appraises for $180,000. 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 accomplish two goals at once: securing a better interest rate and providing a bit of cash to improve the house.

In addition, since the closing costs will be rolled into the new loan amount, the borrower doesn’t have to pay upfront for the refinance, instead pocketing up to $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 lower interest rate and immediate cash benefit.

The bottom line: Consider a limited cash-out refinance if you don’t have a lot of home equity

A limited cash-out refinance makes the most sense for borrowers who haven’t built much equity in their homes, want to lower their mortgage interest rate and have a need for up to $2,000 in cash.

Thinking of refinancing your home? Begin the application process today with Rocket Mortgage^®.