FHA Cash-Out Plan: How It Works

Are credit card balances keeping you awake at night? Do you look at the interest charged on the statements every month with shock, thinking, I could have bought an airline ticket for that! If so, you will understand why banishing outrageous credit card debt is one of the best uses for an FHA cash-out refinance.

Contrary to what you might think, everyone can apply for an FHA cash-out refinance. You don't need to have an FHA loan currently. This makes an FHA cash-out plan worth considering if you'd like to leverage increased home equity to pay off credit cards, make critical home repairs, renovate to boost value, or tackle unexpected medical bills.

Cash-Out Refinance Basics

What is a cash-out refinance? Simply put, you take out a new mortgage for a higher amount than you owe, pay off the old mortgage, and keep the difference in cash.

The amount you can borrow is based on the current value of your home. In recent years, homes have appreciated considerably, widening the gap between what homeowners owe and their home's value. The wider the gap, the more cash is available to release with a cash-out refinance.

For example, let's say you owe $190,000 on a home worth $325,000. You could refinance to a new loan amount of $240,000, pay off the old mortgage, pay $9,000 in closing costs, and be left with $41,000 in cash:

Loan Amount – Old Mortgage – Closing Costs = Cash
240,000 – 190,000 – 9,000 = 41,000

Closing costs, some of which are negotiable, usually add up to be 2% to 6% of the loan amount.

How Is an FHA Cash-Out Plan Different From a Conventional Cash-Out Refinance?

An FHA cash-out plan differs in several ways. Here are four primary features you won't get with a conventional cash-out refinance mortgage.

Interests rates are somewhat lower for FHA cash-out plans.

In general, the interest rates for FHA cash-out refinancing plans are 0.10% to 0.15% lower than rates for a conventional cash-out refi.

Wider eligibility for FHA cash-out plans.

More people are eligible for an FHA cash-out refinance because the minimum credit score is lower, 580. That's not to say that every lender will issue an FHA mortgage to borrower with a score of 580. Some lenders want slightly higher scores for FHA loans, around 600 to 620. But in general, the door is open to more people because FHA cash-out refinance loans are more accepting of lower credit scores. The drawback, of course, in the interest rate. Generally, the lower your credit score, the higher your interest rate.

Related
The basics of refinancing an FHA loan

More cash is available with an FHA cash-out plan.

Lenders of conventional cash-out refinance mortgages cap the amount of equity you can cash out to 80%. The idea is they want you to retain 20% equity in the home. So if your home is worth $300,000, the maximum amount of a conventional refinance loan will be $240,000 (80%). In contrast, FHA cash-out refinance loans allow qualified homeowners to borrow up to 85% of the home's worth—or 95% if the mortgage is less than a year old and all payments have been on time.

You must pay mortgage insurance.

Conventional cash-out refinance lenders require you to keep 20% equity in the home, as mentioned. That's because 20% is the threshold when private mortgage insurance becomes unnecessary. All FHA loans, however, require mortgage insurance (1.75% of the new loan amount up front and 0.85% of the loan amount annually in 12 payments per year).

Therein lies the rub. This insurance requirement will probably offset any savings you get from a lower interest rate if you were to take out an FHA cash-out refinance. For borrowers with good credit who want to take out some cash but retain at least 20% equity, a conventional cash-out refinance is probably better financially.

Several FHA Refinance Plans Are Available to Help Borrowers in Different Situations

The FHA offers four kinds of refinance mortgages. The U.S. Department of Housing has prepared a helpful document explaining the plans, which you can download here.

• FHA Secure is available to people who have conventional mortgages, either fixed-rate or ARM, and are current with the payments. Delinquent ARM holders can also qualify so long as the delinquency was caused by a rate reset.
• FHA-to-FHA Refinance is a streamline refinancing option for people with an FHA loan already.
• FHA 95% Cash-Out Refinance is for anyone with a mortgage younger than a year, whether conventional or FHA. All monthly payments (up to 12) had to have been made on time.
• FHA 85% Cash-Out Refinance is what the 95% cash-out plan becomes if the current mortgage, whether conventional or FHA, is older than a year.

How an FHA Cash-Out Plan Works

The steps in an FHA cash-out refinance are similar to those in a conventional cash-out refi. Here is an overview of the process.

Estimate your equity.

Equity, a fancy term for ownership, is the difference between your home's current value and the balance on the mortgage. On day one, your down payment represented your equity. As you whittle down the loan balance in regular monthly payments, and as housing prices rise, your equity grows.

To estimate how much your home is worth today, you can use this equity calculator at the FHA. You enter your state, the purchase price, and the start/end dates to see how much the value of your home has changed since you bought it.

Another way to get a ballpark figure of what your home is worth is to see what similar homes have sold for in your area. That's what Zillow does, although you should take those "Zestimates" with a grain of salt, cautions realtor Bill Gassett.

"Zillow and their Zestimate of value is not accurate," he stated bluntly in an advice forum. "In fact, if you look at the fine print on their site they will tell you so themselves. Their accuracy is appalling." Due to this, some seekers of cash-out refinancing think a lot more cash is available than what the home appraisal eventually shows.

Once you have estimated your home's current value, simply subtract your mortgage balance. The difference is your equity. The more equity you have, the more cash you can release with an FHA cash-out plan.

As you proceed with an FHA cash-out plan, the lender will require a home appraisal to pinpoint its current value.

Find an FHA mortgage lender.

As with finding any other kind of lender, shopping around is important. Compare options at three or four FHA mortgage lenders, a task we make incredibly simple. Lendgo can help you find your ideal FHA mortgage lender. The FHA insures the loan but doesn't actually loan the money; you'll be dealing with ordinary lenders. When comparing, you may find that a lender you already know, such as your bank, handles FHA loans too.

Complete an application.

Refinance loans require a lot of paperwork, though perhaps not as much as when you bought the home initially. Potential lenders will want to know your name, address, and Social Security Number so they can proceed with a credit check. You will also provide documentation to show your income and monthly debt payments because the resulting ratio, your DTI, is key to evaluating borrowers.

Close the deal!

If your FHA cash-out plan is approved, you will meet with the lender to sign closing papers and pay the closing costs. Although these costs can be rolled into the refinance loan, doing that makes closing costs a lot more expensive, so it's advisable to pay them with some of the cash you're getting out. Shortly after closing day, you'll receive a wire transfer or cashier's check for the amount you cashed out. (This cash is not taxable as income.)

Key Takeaways About FHA Cash-Out Plans

• You don't need to be paying down an FHA loan to qualify for an FHA cash-out refinance.
• FHA cash-out refinance loans have slightly lower interest rates than non-FHA but will require mortgage insurance.
• The FHA will back a loan for up to 85% (sometimes 95%!) of your home's worth.
• FHA loans have looser requirements for credit scores and debt-to-income ratios.