FHA cash-out refinance: how does it work?

As a homeowner, the most valuable asset that you own is likely your home. If you have repaid a significant amount of your mortgage, you will also likely be able to borrow more money for major expenses. These often include major home renovations or college tuition for your children.

This is where an FHA cash-out refinance comes in. FHA stands for Federal Housing Administration, and it is one way to leverage the equity in your home.

In this article, we will look at what a cash-out refinance FHA is, how it works, and who is eligible. Here is everything you need to know about an FHA cash-out refinance.

What is a cash-out refinance FHA?

An FHA cash-out refinance is when you pay off your current mortgage with a new, larger mortgage that is insured by the Federal Housing Administration or FHA.

The amount of the larger loan is based on the amount of equity you have built up in your home. It also includes the amount you still owe on your existing mortgage and how much extra money you need.

With an FHA cash-out refinance, your new mortgage would ideally have a lower interest rate than your previous loan.

Cash-out refinance FHA: how it works

You can use an FHA cash-out refinance if you have built up home equity, which means the home is worth more than you owe on the mortgage.

When doing a cash-out refinance, you take out a new mortgage for more money than you owe on your old mortgage, which is then repaid. The mortgage lender then gives you the difference as a lump sum and can be used however you like.

An FHA cash-out refinance works similarly, except the loans are insured by the FHA. Since it is government-backed, you might be eligible for lower rates than you might get with other refinancing options. You might even qualify if your credit score is less than ideal.

Cash-out refinance FHA: example

To give you an idea of how an FHA cash-out refinance works, let’s take a look at an example. Say you owe $200,000 on your current mortgage and home appraisal has determined the property is worth $400,000. If you got an FHA cash-out refinance, you could borrow as much as 80% of the home’s value, or $320,000.

If you needed $100,000 for home improvements, you would undo a new mortgage application process, like you did for your first home loan, for a $300,000 loan instead. If approved, $200,000 of that would go toward paying off your previous mortgage. And instead, you will start making repayments on your new $300,000 mortgage each month.

As with any type of refinancing, you must also consider closing costs. This is just another factor to consider if you are planning to roll those expenses into your new home loan.

Cash-out refinance FHA: requirements

The FHA has minimum requirements for FHA loans. These minimum requirements include FHA cash-out refinance. However, FHA lenders are also able to set their own standards in addition to the FHA requirements.

Here are the requirements for FHA cash-out refinance:

Credit score

FHA loans are popular for allowing credit scores as low as 500. For FHA cash-out refinance, however, you will need a higher credit score to get the best deal. While some mortgage lenders will approve a credit score as low as 620, the lowest rates are reserved for borrowers who have a credit score of at least 740. It is a good idea to improve your credit score before applying for an FHA cash-out refinance.

Debt-to-income (DTI) ratio

Most of the time, your debt-to-income (DTI) ratio cannot be higher than 43%. If you have other debts or loans, you should try and pay them down prior to applying for an FHA cash-out refinance.

Loan-to-value (LTV) ratio

After the FHA cash-out refinance, you must have 20% minimum equity in your property.

Loan limits

Despite how much your home is now worth, there is a cap on how much money you can borrow. In most US states, the loan limit is $420,680 for a single-family home. In some high-priced areas, however, the loan limit is $970,800.

Mortgage insurance

All FHA loans require mortgage insurance, including cash-out refinance FHA. You will pay an up-front premium of 1.75% of the loan amount. After that, you will pay an annual premium for the following 11 years ranging from 0.45% and 0.80% of the loan amount. The percentage depends on the length of your new mortgage.

Most FHA loans require mortgage insurance for the whole term. However, any with a 90% LTV ratio can opt out after 11 years.

For other refinancing options, see how cash-out refinance compares against home equity loans.

Occupancy/property requirements

The home you do an FHA cash-out refinance on must be your primary residence. Plus, you will need to have lived in the home for at least the previous 12 months.

If you moved into the home six months ago, for instance, you would have to wait before applying for an FHA cash-out refinance.

Payment standing

You also must be in good financial standing with your current mortgage. That means you have made at least the last 12 monthly payments on time.

Can I get a cash-out refinance on an FHA loan?

Yes. You can get a cash-out refinance on an FHA loan. You do not need to be currently paying off an FHA loan to apply for an FHA cash-out refinance. Even if you are currently paying off a conventional mortgage—i.e., one that is not government-backed—you can apply for an FHA cash-out refinance.

You can also apply for an FHA cash-out refinance if you own your home free and clear of mortgages but want to take out some home equity.

If, however, you do have an FHA loan, you can refinance with an FHA Streamline refinance. This usually requires less paperwork. However, the amount of money you can cash out is $500 maximum.

Is a cash-out refinance FHA worth it?

If you want to refinance your mortgage, you can use an FHA cash-out refinance. This is available to you even if your current mortgage is not an FHA loan. Before applying for an FHA cash-out refinance, however, you should weigh the benefits and the risks against other forms of borrowing.

In this section, we will break down the pros and cons of a cash-out refinance FHA to determine if it is worth it for you.

Cash-out refinance FHA: pros

The pros of a cash-out refinance FHA are:

• Low interest rates: Generally, FHA loans have significantly lower interest rates. This makes FHA loans a relatively inexpensive way to borrow, especially compared to other forms of debt, like credit cards or personal loans.
• Low credit score minimums: Once again, compared to most other forms of credit, FHA loans have lower credit score minimums. How low? You can qualify for a loan with a credit score as low as 500.
• Larger loan amounts: Since you are borrowing against the equity you have built up in your home, you can typically get more money with an FHA cash-out refinance. This is true especially when compared with personal lines or lines of credit.

The funds you get from an FHA cash-out refinance can be put toward major home renovations. 

Cash-out refinance FHA: cons

Here are some of the cons of a cash-out refinance FHA:

• More debt: You are taking on a mortgage for more money than you currently owe when you take a cash-out refinance loan. This means you will have to pay more in higher monthly payments. This, in turn, also means you put yourself at greater risk of falling behind on them if you face financial difficulties such as losing your job.
• Risk to home: Like most types of mortgages, your property serves as collateral for the new loan. If you default, the mortgage lender can foreclose on it. With other loans, like credit cards or personal loans, your home does not serve as collateral. This means it is not at risk in the same way.
• Closing costs/fees: You will be on the hook for closing costs and fees when you apply for an FHA cash-out refinance loan. These closing costs and fees will reduce your available cash by a few thousand dollars. Compared to other types of borrowing, cash-out refinance FHA requires more fees. (However, most other types of borrowing will likely come with higher interest rates.)

Cash-out refinance FHA: closing thoughts

If you want to do a cash-out refinance FHA, finding out whether you qualify or not is an important first step. Understanding how a cash-out refinance FHA works, and the various requirements you will have to meet, are also critical in securing a cash-out refinance FHA.

Remember: the more knowledge you have, the better off you will be.

For help in getting an FHA cash-out refinance, get in touch with one of the mortgage professionals we highlight in our Best of Mortgage section. Here you will find the top performing mortgage professionals across the USA.

Did you find these tips useful? Do you have experience with a cash-out refinance FHA? Let us know in the comment section below.