Do Cash-Outs Come With A Tax Break?

First you need to understand what a cash-out refinance is. In such a refinance, you swap your existing mortgage loan for a new mortgage in which you borrow a higher amount. You use the found cash to pay for whatever you’d like.

For example, say you owe $150,000 on your current mortgage. You might refinance that for a new mortgage with a balance of $220,000. You’d then receive the extra $70,000 in a lump-sum payment. You could use that money to pay for anything from a kitchen remodel to a master bedroom addition to your child’s college tuition.

There are some limits. The amount you can borrow with a cash-out refinance is limited by the equity in your home. Equity is the difference between what your home is worth and what you owe on your mortgage. If your home is worth $350,000 and you owe $200,000 on your mortgage, you have $150,000 in equity. Your lender will let you borrow a portion of that equity in the form of a cash-out refinance.

You’ll also have to pay closing costs, which could eat into the money available to you. These costs vary but are typically 2% to 5% of the amount that you borrow. You can usually roll these costs into your total loan amount instead of paying them up front.

What about the tax break?

If you use the funds from a cash-out refinance to improve your home, boosting its value, you can claim the interest that you pay on your new loan on your income taxes. For a new loan, you can deduct the interest you pay on up to $750,000 of mortgage debt.

This means that you can deduct the interest you pay if you use your cash-out refinance to pay for a new bathroom, master bedroom addition, second-floor addition or major kitchen remodel. Any home-improvement project that is expected to increase the value of your home will qualify you for the mortgage interest deduction.

If you instead use the funds from a cash-out refinance to pay off your credit card debt, build an emergency fund or pay for a child’s college tuition, you can’t deduct the interest you pay. That’s why the best use for a cash-out refinance, just as for any home equity loan, is to cover the costs of home improvements.

As a reminder, this is just a summary of complicated provisions that are subject to change. Do not make any assumptions on your tax situation before you speak with a qualified tax professional.