Typically, home values increase over time. Additionally, your mortgage balance usually decreases as you make monthly payments. Combine these two factors and it’s easy to see how you could end up with a house worth significantly more than you owe on it after a few years.
The difference between your home’s value and the amount you owe is called your home equity. One way to get cash for your home equity is by taking out a cash-out refinance mortgage.
But is a cash-out refinance mortgage a good idea for your situation? Here’s what you should consider.
What is cash-out refinancing?
When your home is worth more than you owe, your home equity can be a large part of your net worth. Unfortunately, you can’t access this part of your net worth like you’d be able to with other investments such as stocks or bonds.
You can’t sell a single bedroom in your home when you need cash to help pay for a large expense that unexpectedly pops up. Instead, you have to unlock your home equity in other ways.
A cash-out refinance mortgage is one way you can access the equity in your home. This type of mortgage works by refinancing your current mortgage.
In a traditional mortgage refinance, you take out a new mortgage worth roughly the same amount you owe on your old mortgage. You use the proceeds from your new loan and pay off the old mortgage. These types of refinances are normally used to secure a lower interest rate or change other terms of your loan, such as its length.
A cash-out refinance mortgage, on the other hand, allows you to borrow more money than it’d take to pay off your current mortgage.
The extra money above the amount needed to pay off the original mortgage is paid to you and is typically deposited in a bank account. You can use this money for anything you want as long as the mortgage doesn’t specify otherwise.
Who can take a cash-out refinance mortgage?
You must have home equity
The first requirement you must meet to take out a cash-out refinance mortgage is having equity in your home. The exact amount of equity you must have varies from lender to lender and by the type of loan you take out.
In general, you should leave about 20 percent equity in your home after you cash out. That means if you have 40 percent equity in your home prior to a cash out refinance, you can take out roughly 20 percent in a cash out refinance.
There are types of loans that allow you to leave less than 20 percent equity in your home after a cash out, but they may not be the best idea for most situations. Generally, if you leave less than 20 percent equity in your home, you’ll have to pay private mortgage insurance (PMI) which can add even more costs to your monthly mortgage payment.
You’ll need to meet typical mortgage requirements
Once you’ve verified you have enough equity to borrow against, you need to make sure you can qualify for the mortgage. You’ll need to meet the typical mortgage requirements to take out a cash-out refinance loan.
These include having an acceptable credit score, keeping total debt below the debt-to-income ratio cap, and any other requirements the lender states.
The interest rate you get on your cash-out refinance mortgage depends on many factors. The biggest factors are your credit score and the current interest rate environment. If rates have decreased since you took out your original mortgage or your credit score has increased, you may be able to secure a lower interest rate.
That said, if you leave less equity in your home when you take out a cash-out refinance mortgage, expect to pay a slightly higher interest rate than those offered for loans with at least 20 percent equity left in the home.
Potential benefits of taking out a cash-out refinance mortgage
Depending on how you use the money you cash out during the refinance process, it might be a smart move.
Pay off higher interest rate debt
Since cash-out refinance mortgages normally come with relatively low-interest rates, they provide a good opportunity to pay off higher interest rate debt.
Moving credit card debt with a 17.99 percent APR to a mortgage with a much lower APR could save you a ton of money if you pay off the debt on the same repayment schedule.
Lower overall monthly debt payments
A cash-out refinance mortgage is typically repaid over 15 to 30 years. If you use the proceeds from the cash out to consolidate your debt, you could drastically lower your monthly debt payments. This can help you get through a rough financial patch while still paying your bills on time each month.
Get cash for other uses
Cash-out refinance mortgages don’t have to be used to pay down other debt. You could use the proceeds to finance other purchases such as home improvements or college costs for your child.
You could even buy a new car or a recreational vehicle (RV) if you wanted to. Not every purchase is a smart idea, so make sure you think through the purchase before using your home equity to buy it.
Lower your interest rate
If mortgage rates have dropped since you originally took out your loan, a cash-out refinance mortgage could give you the opportunity to lower the interest rate on your mortgage in addition to accomplishing other goals. Due to the normally large balances that come with mortgages, this could save you quite a bit of money if interest rates have dropped substantially.
Interest may be tax-deductible
While the deductibility of interest has changed with the new tax law, you may be able to deduct the interest you pay on your new cash-out refinance mortgage. If you use the money from the cash-out refinance to improve your home, it may be tax-deductible.
Consult with a tax professional to determine the deductibility for your planned uses before you consider taking out a loan.
Potential drawbacks of cashing out your equity
A cash out refinance mortgage isn’t always a smart idea. In fact, there are many reasons you may not want to take out this type of loan.
It could lead to foreclosure
Unfortunately, life doesn’t always go as expected. If you end up defaulting on your new mortgage, your house could be foreclosed on. This may not have been an issue if your prior mortgage had a lower and more affordable payment.
It may extend the length of your mortgage
When refinancing, taking out a new 30-year mortgage often gives you the lowest monthly payment. This seems attractive because it lowers your monthly expenses. However, it restarts the clock on owning your home outright.
If you’ve been paying off your home for 10 years already, taking out a 30-year mortgage means it will actually take a total of 40 years to pay off your home if you stick to the new schedule.
You may pay more interest over the long term
Just because a mortgage offers a lower interest rate doesn’t mean you’ll pay less interest. Even if you consolidate high-interest rate debt using a cash-out refinance, you could pay more interest if you take the full 30 years to pay it off.
Run the numbers using a loan calculator to see how much interest you’d pay with your current loan versus a cash-out refinance loan to see which is a better deal for you.
Closing costs can be expensive
Taking out a mortgage is an expensive proposition. Whenever you take out a mortgage, you usually have to pay closing costs in one form or another. Closing costs can vary from area to area, but you may have to pay around three percent in closing costs upfront. This is a hefty cost of borrowing money that you must carefully consider.
You may be putting a temporary bandage on your financial problem
A cash-out refinance mortgage can give you a nice buffer in your bank account. Sadly, it gives many people a false sense of security. If you have financial problems that caused you to rack up debt, a cash-out refinance may not help you fix your problem even though it pays off the debt.
Unless you’ve gotten to the root of why you incurred debt and fixed that issue, a cash-out refinance will only be a temporary fix until the cash runs out again.
You might have to pay private mortgage insurance again
If your cash-out refinance mortgage leaves less than 20 percent equity in your home, you’ll likely have to pay private mortgage insurance. Factor in this added cost into your calculations to see if a cash-out refinance really is cheaper than other loan options, even if they come with higher interest rates.
Options if cash-out refinancing is not for you
You might have other options to borrow the money you need without tapping your home’s equity.
A personal loan is typically an unsecured loan, which means your house can’t be foreclosed on if you end up defaulting. Personal loans can often get you the cash you need, but they may come with much higher interest rates than a cash-out refinance mortgage.
You can find personal loans that come with no origination fees so you can avoid the hefty closing costs you might have to pay with a cash-out refinance mortgage.
You can find the personal loan that matches up with your needs through aggregators like Lending Tree. LendingTree will show you all your loan options in one place!
0% introductory APR credit cards
0% introductory APR credit cards also might be able to help you avoid a cash-out refinance mortgage. Some of these offers work for new purchases, balance transfers or both.
Either way, make sure you pay off the balance on the card before the introductory 0% APR period expires or you could be faced with high-interest charges.
Our current favorite 0% intro credit card is the Citi® Diamond Preferred® Card, which offers 0% for 12 months on Purchases. The everyday APR when the intro rate expires is 13.74% - 23.74% (Variable).
Home equity loans or lines of credit
A home equity loan or line of credit allows you to leave the original mortgage on your home untouched. Instead, you cash out your equity with one of these types of loans that is completely independent of your original mortgage.
Because these mortgages are usually secondary to a primary mortgage, expect to pay a higher interest rate than you likely would with a cash-out refinance mortgage. Even so, their flexibility might offer a better option than refinancing your mortgage to cash out.
Now that you understand what a cash-out refinance mortgage is, you can determine if they’re the right move to assist with your current financial situation. If it sounds like the best option available, start looking for a lender to refinance with.
It may be that cashing out your equity isn’t the best choice for you. If another borrowing option sounds like a better solution, start investigating the different offers to find the best solution for you.