Cash-Out Refinancing: When Does it Make Sense?
12/15/2016 Kristin Demshki
For many people, one of the benefits of homeownership is having the opportunity to use their home equity to access needed cash. While there are many options to get that money into the piggy bank, an attractive option for many is a cash-out refinance.
What Is a Cash-Out Refinance?
A cash-out refinancing takes place when a homeowner secures a new loan to replace the current mortgage, for more than the amount currently owed. The homeowner is then able to use the additional cash refinanced to pay off higher interest debt such as credit cards or to make home rennovations.
This differs from a traditional mortgage refinance, when the original loan is replaced with a new loan, typically with a lower interest rate and new set of terms. A homeowner with an adjustable-rate mortgage, for example, may refinance into a 30-year-fixed-rate loan so they can have predictable payments in the future. It offers long-term benefits, but may not be the right choice for someone who has an immediate need for cash.
Over the years, cash-out refi loans took a bad rap, especially during the housing boom, when too many homeowners relied on the method to stay above water. Following the recession, however,tighter lender restrictions and better consumer education has lent itself to a more responsible borrowing environment. In fact, while cash-out refis accounted for roughly 80% of refinanced mortgages during the mid-2000s, they make up just 17% of new refinancings, today.
Today, home values have risen in many regions of the country, and this increase in home values has led to the resurgence of cash-out refinancing among some lenders.
Benefits of Cash-Out Refinance Loans
Here are a few possible benefits of a cash-out refinancing:
- Increase your credit score: When homeowners use the funds from a cash-out refinance to pay off high-interest credit card debt, it does not only eliminate the higher-interest credit card monthly payments, but paying down your credit card can have a positive effect on your credit score. Just remember to use this approach sparsely — it shouldn't become a regular habit.
- Consolidate debt: With credit cards paid down, or paid off in full, credit utilization goes way down, which could also have a positive impact on your credit.
When used appropriately, cash-out refinancing can be a great option to leverage home equity. Yet, similar to making any other major financial decisions, each of its pros and cons must be weighed.
So, how do you know if a cash-out refinancing option is right for you? Here are some key points to help you consider your options.
A Cash-Out Refi Isn't an ATM
It's important for homeowners to understand why they are opting for a cash-out refinance loan. Would it be used to replace your leaky roof? To buy a new car? To consolidate debt? Or would the money be used to fund an exotic European vacation instead? If any of your reasons fall into the latter, it might be more reasonable to consider a personal loan.
When you choose a refinance cash out loan, you are putting your home on the line. Your house will be put up for collateral, and full, on-time payments must become a top priority. If you are using a cash refinance to remedy bad financial habits, you could find yourself in a heap of trouble.
There are some situations where taking cash out of your home equity is smart, or even necessary, but it's something you should absolutely think about. If you don't really need the money, it probably makes more sense to go the route of a traditional refinance.
Look for Changes in Your Interest Rate
In the housing boom, many people turned to cash-out refinancing to replace soaring interest rates, with lower ones. Today, low mortgage rates have kept many homeowners at bay. In fact, in some cases, choosing a cash-out refinance option may increase your interest rates, so it's important to consider your cost-return.
Along that line, you could also be increasing your lifetime interest rates substantially. Cash-out refinancing restarts the amortization process. With a cash-out refinance you will pay a 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, much like when you secured your home mortgage the first time around.
Don't Forget About Closing Fees and Costs
And on that note, you will also have to pay a second round of closing costs and fees. These can run anywhere from hundreds of dollars, to several thousand. Of course, the smaller the cash-out balance the less attractive your return on costs will be.
Take a close look at costs and weigh it against how you plan to use the funds. Ordinarily, borrowers refinance to obtain better loan terms — a lower interest rate, a shorter term, or a predictable monthly payment when switching from an adjustable rate mortgage (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 payment. In some cases, it may be better to preserve your existing mortgage, or borrow with a home equity loan (HEL), or a home equity line of credit (HELOC).
Only you can decide what loan option is best for you. Don't be shy about reaching out to your lender. An expert opinion can help you better consider your options, and help you get your finances in order.
Wondering What a Cash-Out Refinance Might Look Like for You?
Let's take a look at Susan. She just bought a beautiful brick bungalow in December 2012 for 3.25%. She's now thinking about refinancing her home, and taking $25,000 out in cash to make some improvements around the house.
In the example below, Susan will pay an extra $136 a month, $4,525 in points and fees, and about $44,000 in lifetime interest for the $25,000 cash she received. Fortunately, the cash was used on home renovations further increasing her home value.
Check out the chart below to consider whether a cash-out refi may benefit you:
|Current Loan||Cash-Out Refinance|
|Fixed Interest Rate||3.250%||4.250%|
|Loan Start Date||12/2012||4/2014|
|Loan Payoff Date||11/2042||5/2044|
|Lifetime Interest Expense||$113,349||$157,685|