Cash-Out Refinancing: When Does it Make Sense?

Cash-Out Refinancing: When Does it Make Sense? A smartly executed cash-out refinance could help you lower your monthly payments and access needed cash.

For many people, one of the top 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, one of the most attractive options 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 pocket the difference, and use the money at their choosing.

This differs from a traditional mortgage refinance, when the original loan is replaced with a new loan, typically with a lower interest rate and a revamped 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 equity has led to the resurgence of cash-out refinancing among some lenders.

Benefits of Cash-Out Refinance Loans

Here are a few notable advantages of a cash-out refinancing:

  • Increase your credit score: When homeowners apply the funds from a cash-out refinance to pay off credit cards, it can not only saves money in the way of late fees and high-interest, but can also give you a clean slate. 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 save thousands and make credit available to you again.
  • Take advantage of tax deductions: Following a cash-out refi, homeowners have to pay mortgage interest payments. Luckily, those are tax deductible.

When used appropriately, cash-out refinancing is 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 spring for a personal loan.

When you choose a refi cash out, 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 refi.

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Look for Changes in Your Interest Rate

Look for Changes in Your Interest Rate In the housing boom, many people turned to cash-out refis to replace soaring interest rates, with lower ones. Today, historically 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 refi 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 (HOL), 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, get your finances in order, and avoid any potential financial risks.

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 scenario below, Susan will pay an extra $136 a month, $4525 in points and fees, and about $44,000 in lifetime interest for the $25,000 cash she received. Fortunately, the cash she borrowed was used wisely and she improved her home equity overall.

Check out the chart below to consider whether a cash-out refi is poised to benefit your future.

  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