With home values increasing and interest rates remaining low, some homeowners are choosing to generate cash from their equity. This can make a great deal of sense if you’re looking to start a business, consolidate debt, send a kid to college, or remodel your kitchen. One of the simplest methods to generate cash from equity is cash-out refinancing.
What is cash-out refinancing?
Cash-out refinancing lets you use your home as a piggy bank. The homeowner takes out a new mortgage for a higher amount than the existing mortgage and takes the difference in cash. If you owe $100,000 on your house and take out a new mortgage for $150,000, you keep the difference ($50,000) in cash at closing. The homeowner can take this money and use it for any major expense, from credit card debt to medical bills. Like any refinance, this results in a new loan at a fixed interest that may be lower or higher than your previous rate.
Pros and Cons of Cash Out Refinancing
Who is cash out refinancing for?
Jane has a home in a desirable area, but her home is old and outdated. She wants to remodel her kitchen and her bathroom. Jane’s home is valued at $400,000 and she owes $200,000, which means she also has $200,000 dollars in equity. She refinances her home, and takes a loan for $250,000. This leaves her with $50,000, minus fees, to spend on the island in the kitchen, new appliances, the separate shower and tub in her bathroom, and marble granite floors. She spends most of the $50,000 on upgrades. Jane’s home now has a higher value, and she gets to live with the new kitchen and bathroom until she wants to sell.
What are the pros of cash out refinancing?
- Lower interest rate: The interest rate could be lower than your current rate. If Jane bought her house in 1995, the interest rates were close to 9%. Because she refinances, her new mortgage has a rate closer to 4%.
- It can be better than alternatives: A cash-out refinance has a lower interest rate than alternatives like a home equity line of credit (HELOC) and a home equity loan (HEL). HELOCs have variable interest rates that fluctuate with the market. HELs have a fixed interest rate, but it is a second loan that you have to pay monthly.
- Debt consolidation: If Jane had $50,000 in credit, she could use the cash to pay off this debt. This makes sense in the short-term, as her credit cards have an exorbitant rate by comparison. But she also needs to look at this long term: her new loan will accrue interest for 30 years. Also, her spending habits will need to change.
- Tax deductible: Unlike credit card loans, mortgage interest payments are tax deductible. This means Jane could lower her taxable income, leading to a larger refund in April.
- Higher credit score: If she uses her cash to pay off credit card debt, Jane will improve her credit score because it will reduce the amount of available credit she is using.
What are the cons of cash out refinancing?
- Potentially high closing costs: As we mentioned, James has to pay between 3%-6% of his new loan in closing costs. For a $220,000 loan, this would be between $6,600 and $13,200.
- The risk of foreclosure: With his new monthly payment, James has to pony up more money each month. If he can’t make this extra payment he is at risk of defaulting on his new mortgage, with his home as collateral.
- May be required to purchase private mortgage insurance: If you borrow more than 80% of your home’s value you may get saddled with private mortgage insurance (PMI). This can be an extra payment of up to 1% of your loan per year.
- Undisciplined spending habits: If James uses his cash to pay credit debts, he’s immediately freeing up his available credit. A cash-out refinance should not be taken to enable bad habits.
- Inconvenient process: You’ll need to go through the same process you went through to get your first loan. W-2s, tax returns, pay stubs, and so forth.
How can cash out refinancing get you in financial trouble?
James has a home valued at $600,000. His current loan is for $200,000, so he has $400,000 in equity. He refinances his loan for $220,000, and keeps the $20,000. He has to pay over $6,000 in closing costs (about 3% of his loan), which he rolls into the loan. He uses most of this money to splash out on a dream trip to Fiji. He now has a mortgage of $220,000 with no new value added to his home. This means he’s paying slightly more than $100 per month over a term of 30 years. This strains him financially so he cannot make upgrades to his home, and the value of his home doesn’t increase as quickly. He has some great pictures from the trip, but he now works one Saturday a month for the next few years just to make up for this extra expense.