A cash-out refinance in Canada, often referred to as an equity takeout refinance, is a type of mortgage refinancing that allows homeowners to leverage the home equity they have built. This involves replacing your existing mortgage with a new, larger one, receiving the difference as a lump sum of cash.
What is a cash-out refinance?
A cash-out refinance means you take out a new mortgage loan for more than the amount still owed on your current mortgage, with the extra money above your existing mortgage balance paid out to you in cash.
A cash-out refinance differs from a standard mortgage refinance in that the new mortgage is taken out for the remaining balance owed on the current one. With a cash-out refinance, you intentionally borrow more to withdraw home equity.
How much cash can you access through a cash-out refinance?
Most lenders will let you borrow up to 80% of your home’s appraised value through a cash-out refinance. However, you can only tap into your accumulated equity, not counting your current mortgage debt.
Let’s look at an example:
- Home value: $500,000
- Existing mortgage: $300,000
- Total equity: $200,000
Since 80% of $500,000 is $400,000, you may qualify to borrow up to this amount. However, when you subtract your current mortgage balance of $300,000, the maximum cash you can take out is $100,000.
In this scenario, you could refinance into a new $400,000 mortgage and receive $100,000 in your pocket. Just remember the 80% limit is based on your home value, while the actual cash out depends on your built-up equity.
The process of how cash-out refinancing works
Here is a step-by-step overview of how to get a cash-out refinance in Canada:
Step 1: Calculate your home equity
Your home equity is calculated by taking your home’s current value and subtracting any outstanding mortgage debt tied to the property. This is known as the loan-to-value (LTV) ratio. An appraisal will be required to officially determine the home’s market value.
Loan-to-Value (LTV) ratio explained
The LTV ratio is a critical factor in determining your eligibility for a cash-out refinance and the interest rate you’ll receive. A lower LTV ratio generally indicates lower risk for the lender, which can translate to more favorable terms. It’s important to maintain a healthy LTV to avoid potential financial strain and protect your home equity.
Step 2: Determine the maximum loan amount
Most lenders will let you borrow up to 80% of your home value. However, you can only borrow against the available equity, not including your mortgage balance.
Step 3: Complete the refinance
After choosing a lender and loan amount, complete the refinance application process. This process involves documentation, appraisal, credit check, and, potentially, retaking the mortgage stress test.
Step 4: Receive the cash
Once approved and closed, your new mortgage will be used to pay off the old one. The difference between the two loan amounts will be paid out to you in cash.
What are the pros and cons of a cash-out refinance?
Carefully weigh the following pros and cons of a cash-out refinance based on your specific financial situation:
| Pros | Cons |
|---|---|
| Access larger loan amounts: Borrow more than you could with a personal loan or line of credit. Lower interest rates: Mortgage rates are generally lower than other financing options. Consolidate debts: Pay off higher-interest debts like credit cards or loans. Improve credit: Reducing high credit utilization can help boost your score. | Increased mortgage amount: Your housing debt and monthly payments will go up. Interest costs: You’ll pay more interest over the life of a larger loan. Closing costs and fees: Refinancing comes with upfront costs. Foreclosure risk: Not making larger payments could risk foreclosure. |
How do you qualify for a cash-out refinance?
To qualify for a cash-out refinance mortgage, you will need to have at least 20% equity built up in your home. The more equity you have, the more cash you can potentially take out.
Most lenders recommend a minimum credit score of 650, but those with higher scores will qualify for better interest rates. Your gross income must be stable and sufficient to support the higher mortgage payments. Many lenders look for a gross debt service ratio below 50% and a total debt service ratio under 50% to approve borrowers.
The lender will require a current appraisal to be completed on the home to confirm its updated fair market value and calculate how much equity is available to borrow against.
If refinancing with a federally regulated lender, you’ll likely need to undergo another mortgage stress test to ensure you can still afford payments at a higher rate.
So, improving your credit score, reducing debt, and stabilizing your income sources will help you meet the requirements to apply for a cash-out refinance.
Best uses for cash-out refinance funds
The proceeds from a cash-out refinance are yours to spend or invest as you wish. However, some uses make more financial sense than others when weighed against the risks of borrowing more. Here are 7 of the wisest ways to utilize cash-out mortgage funds:
- Home renovations or improvements: Remodelling, upgrades or repairs can increase your property value, recouping some or all of your investment.
- Pay off high-interest debts: Consolidating credit card, loan or line of credit balances into your lower mortgage rate can save substantially on interest.
- Start or expand a business: Inject capital into starting a new business or expanding an existing one. Be sure to have a solid business plan.
- Real estate investments: Use them as a down payment on rental properties or for fixing and flipping houses. Perform due diligence on profit potential.
- Education expenses: Pay for vocational training, college tuition, or continuing education to improve income potential.
- Major medical procedures: Use funds to undergo a medically necessary procedure not fully covered by insurance.
- Consumption spending: While less ideal, cash-outs may help fund large purchases, vacations, or basic expenses in a financial pinch.
Avoid tapping home equity just to fund an unsustainable lifestyle. Instead, look for opportunities to use the capital to generate potential returns or future cost savings.
Cash-out refinance vs standard refinance: What’s the difference
While both are types of mortgage refinancing, there are seven key differences between a cash-out refinance and a standard rate-and-term refinance:
| Factor | Cash-Out Refinance | Standard Refinance |
|---|---|---|
| Loan amount | Borrowing more | Remaining principal owed |
| Purpose | Access home equity | Change rate/term |
| Monthly payments | Usually increase | Maintain or decrease |
| Risk level | Higher | Lower |
| Upfront costs | Appraisal, penalties | Discharge fees |
| Tax implications | Non-taxable cash | Lower interest rates may lower deductions |
| Credit impact | Increases debt | Utilization unchanged |
In short, the central distinction is that a cash-out refinance intentionally borrows above your current mortgage amount so that you can withdraw equity, while a standard refinance just gets you a new rate and term without taking equity out.
What are alternatives to cash-out refinancing?
Other home equity borrowing options besides a cash-out refinance include:
- Home equity loan: Provide a lump sum of cash. You’ll receive funds upfront and repay the home equity loan through fixed installments over a set term. The loan is secured by your home, meaning missed payments give the lender the right to foreclose.
- Second mortgage: An additional loan to your existing first mortgage that helps access up to 80% of your home value minus your first mortgage balance.
- HELOC: A revolving line of credit secured by your home’s equity. You can draw funds as needed up to your approved limit and repay on your schedule.
These alternatives have pros and cons. Shop for the best rates and terms for your needs and financial situation.
FAQs about cash-out refinance in Canada
Do I need to pass a stress test for cash-out refinancing?
Yes. If you're refinancing with a federally regulated lender in Canada, you'll likely need to pass the mortgage stress test, which ensures you can handle payments at a higher qualifying rate (typically the higher of your contract rate + 2% or the Bank of Canada's minimum qualifying rate).
What are the costs associated with cash-out refinancing?
Costs typically include appraisal fees, legal fees, potential prepayment penalties on your existing mortgage, title insurance, and possibly mortgage broker fees if you use one.
Is the cash from a cash-out refinance taxable in Canada?
No, the cash you receive from a cash-out refinance is not considered taxable income in Canada because it's a loan that must be repaid, not income. However, if you use the funds to generate investment income, that investment income would be taxable.
What's the difference between a HELOC and cash-out refinancing?
A HELOC (Home Equity Line of Credit) provides revolving access to your equity with variable interest rates and flexible repayment options. At the same time, cash-out refinancing gives you a lump sum by creating an entirely new mortgage, typically with a fixed interest rate and term.
Is there a limit to how often I can do cash-out refinancing?
While there's no legal limit, lenders typically want to see that you've held your current mortgage for at least 6-12 months before refinancing. Frequent refinancing also incurs repeated closing costs, which can erode your equity.
Cash-out refinancing can be a strategic way to tap into your home’s equity if used responsibly. While tempting, it is critical to consider both the benefits and risks before withdrawing cash. Analyze your financial situation carefully, create a repayment plan, and use funds wisely to generate returns. For personalized guidance, connect with a qualified mortgage broker to discuss your options.