Why Cash-Out Refinancing May Not Always Make Sense

Why Cash-Out Refinancing May Not Always Make Sense

If your home value is now comfortably above water, you may be tempted to refinance once again to take cash out from your improved home equity. Cash-out refinances typically have no restrictions on how you use the cash you receive. The proceeds can go towards anything from making home improvements to paying for a child's education or even a new car.

Such loans were popular before the economic downturn, but practically disappeared after home values fell and guidelines tightened. Home values have risen in many regions of the country, however, and this increase in home equity has led to the resurgence of cash-out refinancing among some lenders.

While lenders may be willing to loosen their purse strings based on improving economic conditions – should you be willing to loosen yours? Maybe. But, there are multiple financial consequences that you should carefully weigh before making this important financial decision.

First and foremost is comparing your current mortgage rate to the new cash-out refinance interest rate. According to a recent FHA Housing Study; 54% of responders have refinanced in the last 2 to 3 years, representing millions of US homeowners. If you're one of these smart consumers, you likely have a historically low fixed rate in the 3 to 4 percent range. This rate is definitely worth protecting.

The following are additional important factors to consider before proceeding:

  • Mortgage rates are up.It bears repeating – don't give up your historically low rate too easily for today's higher rates unless it makes financial sense from a cost return perspective.
  • You could be increasing lifetime interest costs substantially.Cash-out refinancing restarts the amortization process. You're now paying the higher interest rate on the full new balance, not just on the newly borrowed cash. This also means that your monthly payment resets to mostly paying interest and not reducing the principal balance.
  • You'll have to recoup the fees and points you pay to originate the loan.You'll likely pay points on your new loan or pay a higher interest rate to avoid them. That, plus standard loan fees, means you're paying thousands of dollars in fees just to borrow the cash. And of course the smaller your cash-out balance is, the less attractive your return on costs is.
  • Is it worth it?This is a question only you can answer. Take a close look at the total costs (see our example below) and weigh it against how you plan to use the funds. Are you making improvements to your home or paying a college tuition? Or are you using the money to take a vacation or pay credit card bills? Some uses make more fiscal sense than others. You may have the immediate gratification of cash in hand, but you could be paying dearly for it. Many borrowers who use their home equity to pay down credit card debt end up back in debt within a few years.
  • Get a second opinion.Some lenders are more consultative than others. It's always worthwhile to speak with more than one lender when considering your options.

A Cash-Out Refinancing Example

Our borrower, James, last refinanced his house in December 2012 for 3.25%. He's now thinking about refinancing and taking $25,000 in cash to make some improvements around the house.

In the scenario below, James will pay an extra $136 a month, $4525 in points and fees, and over $44,000 in lifetime interest for the $25,000 cash he receives today.

  Current Loan Cash-Out Refinance
Original Loan Amount $200,000 $204,525
Cash Out   $25,000
Current Loan Balance $175,000 $175,000
Home Value $325,000 $325,000
Current Monthly Payment $870 $1,006
Current Interest Rate 3.250% 4.250%
Loan Start Date 12/2012 4/2014
Loan Pay Off Date 11/2042 5/2044

Fees

  $2,500
Points   $2,025

Interest Expense

$113,349 $157,685
Additional Lifetime Interest   $44,337

Ordinarily, borrowers refinance to obtain better loan terms – a lower interest rate, a shorter term, or a predictable monthly payment when switching from an ARM to a fixed-rate loan. By refinancing out of your existing low interest rate, you're increasing the amount and term of your mortgage, while raising the interest rate and monthly payment. There are some situations where taking cash out of your home equity is wise or even necessary, but you should weigh all the factors before moving forward.

If you must have funds, keeping your existing mortgage and borrowing with a home equity loan or line of credit can be the less-expensive option. You'll preserve your existing low first mortgage rate and typically have lower closing costs. Talk to your current lender, who can help you compare your options and determine the best fit for your financial situation.