In real estate, refinancing is the process of replacing an existing mortgage with a brand new one with more favorable terms. By refinancing, borrowers can decrease monthly mortgage payments, negotiate lower interest rates, renegotiate the term, remove other borrowers from the loan agreement, or access cash though home equity that has been built over time. This last option is called a “cash-out refinance.”

With this option, the new mortgage is for a larger amount than the existing loan amount. This allows the owner to convert home equity into cash. Typically, this cash is used for home repairs, updating the property, or consolidating debt. 

There are two common types of mortgage refinance:

Investors often use cash-out refinancing to finance additional real estate investments. 

Refinancing pays off an old mortgage in exchange for a new mortgage, ideally at a lower interest rate. A home equity loan gives the owner cash in exchange for the property’s built-up equity.

Home equity loans tend to have lower interest rates than personal, unsecured loans because they’re secured by a piece of property. But here’s the catch: The lender can come after the home if you default. 

A traditional home equity loan is often referred to as a second mortgage—the homeowner still has a primary mortgage, but they have also taken out a second loan against the built-up equity. The second loan is subordinate to the first—should the borrower default, the second lender stands in line behind the first to collect any foreclosure proceeds. 

Because of this, home equity loan interest rates are usually a bit higher than for traditional mortgages and refinances. These loans generally have a fixed interest rate, although some are adjustable. 

Beyond the traditional home equity loan, in which one borrows a lump sum, there’s also the home equity line of credit (HELOC). This works essentially like a credit card that’s tied to the equity in the home for a set time period after it’s received. HELOCs typically have adjustable interest rates. 

Say a home was purchased five years ago with a 30-year fixed-rate mortgage charging five percent interest. Now, in 2020, the average mortgage rate is 3.5 percent—and that difference can save thousands over the life of the loan. But if you already have a low interest rate and simply want additional cash to pay for a new roof or add a patio or a kitchen, a home equity loan may be attractive. 

It’s important to note that cash-out refinance loans tend to have much better interest rates than home equity loans.

A cash-out refinance offers investors the chance to jump-start their real estate investing career without waiting to gather capital for their first deal.

However, there are some drawbacks to investing in real estate via a cash-out refinance. First, you’ll be increasing your monthly mortgage. And if real estate values fall, the added principle could also lead to you owing more on the original property than it’s worth. Plus, a cash-out refinance often resets the loan. If a mortgage has 10 years left, you’ll now be back to 15 or 30 years, depending on the terms of your loan. 

The amount you can cash-out with a mortgage refinance depends on a few key factors, but it’ll usually be between 75 and 85 percent of the home value. Lenders look at the difference between the current mortgage balance and the home’s fair market value. They also use the borrower’s income and credit score to determine how much they’re willing to lend. Additionally, many lenders have their own limits on how much equity you can borrow.

In some cases, the reason you’re refinancing influences how much cash you can receive. For example, if you use the new mortgage to pay off other consumer debt, your debt ratio will subsequently decline—possibly qualifying you for more cash. And if you are making home improvements and thus increasing the value of a property, lenders may permit more cash based on the estimated higher value of the property.

Home equity is the difference between the home’s value and the mortgage balance. If you have a home that’s valued at $250,000 and a mortgage that has $100,000 remaining, the equity is $150,000. 

The amount of equity limits the amount of cash that can be taken out. Cash cannot be more than a property’s value and is generally limited to upwards of 85 percent of the property value. For example, a home worth $200,000 with a mortgage balance of $75,000 means the equity is $125,000.

Your income and debts play a role in determining the maximum mortgage amount. If a credit score is below a lender’s minimum level required for the maximum loan percentage, the lender often reduces loan-to-value limits. 

For example, a mortgage program that permits an 85 percent loan-to-value maximum may only lend 70 or 75 percent because of a lower-than-optimum credit score. This will effectively reduce the amount of cash you can take out. 

Most mortgage loan programs limit the loan-to-value maximum. For example, let’s say your home is worth $500,000 and you have $350,000 remaining on your mortgage balance. Your lender allows a loan-to-value maximum of 85 percent. The most cash you can take out is $75,000. That is determined by multiplying the loan-to-value percentage by the home value and then subtracting the mortgage balance to learn the potential cash-out amount.