Charlie Edler, a licensed Mortgage Expert at Better Mortgage, gives an intro to cash-out refinances and when you might (or might not) want to consider one.
Let’s get straight to it: a cash-out refinance basically lets you take cash straight from the equity in your home. So how does it work? In a nutshell, you refinance your current mortgage for more than what you owe and keep the difference in cash. You’ll get a new loan that consists of your previous mortgage balance plus the cash you took out.
Here’s an example: let’s say your house is worth $300,000 and you have $100,000 left on your current mortgage. That means you have $200,000 in home equity. If you wanted to liquidate $30,000 of this equity, you would then get a new loan worth $130,000 (the $100,000 balance from your original mortgage balance plus the $30,000 you took out in cash).
Common cash-out uses
You can use the cash you take out for any purpose. However, in most cases, people do a cash-out refinance for one of these more common reasons:
Home renovations: People often use their cash-out to reinvest into their home in the form of improvements, repairs, or even major remodels. Whether you use the money for a roof replacement or to add another bedroom, there’s a chance that these improvements can help boost your home’s value (and your equity) in the long run.
Debt consolidation: Some people do a cash-out refinance to pay off other loans like credit card debt, student loans, or a second mortgage. Since mortgages rates are relatively low, moving your high-interest debt to your mortgage might help you save a significant amount of interest in the long term. For example, In 2015, U.S. households paid an average interest rate of 13.66% on credit card debt, while the average mortgage interest rate for that year was 3.85%, almost 10% lower.12 Mortgages also usually have tax-deductible interest and a relatively longer repayment period, offering another opportunity to make your monthly debt repayment more manageable.
Personal costs: Some people use a cash-out refinance for education or medical expenses if they do not have access to other funds. Others who are low on savings may choose to transform their home equity into an emergency savings fund that they can turn to in case of future unexpected expenses. For these personal costs, a refinance can be an alternative to a personal loan, which usually has a higher interest rate and faster repayment term than a mortgage.
Investing elsewhere: Some refinancers use their cash-out funds to invest in retirement, long-term savings plans, another property, or other options that could provide larger returns than the interest they are paying on their mortgage. Make sure to talk to your financial advisor before pursuing this path.
There are some cases when a cash-out might not be the best move. If you use it for things like a new car, vacation, wedding, or risky business venture, there’s a good chance you’ll have little to no return on your money. You’ll still be on the hook to pay that debt off (with interest), and if you’re unable to pay, you could put your home at risk.
Also keep in mind that since lenders view cash-out refinances as riskier, interest rates are generally higher than those for rate-and-term refinances. However, you may still be able to get a better interest rate than your current financing even when taking cash out, particularly if rates have dropped or your credit score has improved since you got your original mortgage. Most lenders also require that your loan-to-value ratio (LTV) stays at or below 80% post-refinance (for a single-unit primary residence; maximum LTVs for other properties may vary).
Cash-out vs. HELOC
You might have also heard of a home equity line of credit (HELOC). While both a cash-out refinance and a HELOC help you utilize the equity you’ve built up in your home, they differ in a few key ways. A cash-out refinance liquidates your equity in a lump sum, but a HELOC does so through a credit line secured by your home. In addition, a cash-out refinance actually replaces your existing mortgage, while a HELOC is a second loan on top of your first one. Cash-out refinances also offer the option of a lower, fixed interest rate, while HELOC interest rates are always adjustable, changing (usually upward) in conjunction with the market index.
The bottom line
If you’re wondering whether a cash-out refinance is the right option, consider weighing the benefit of how you’re going to use the money against the effect it might have on your mortgage’s rate, term, and payments. A cash-out refinance might be a good option if you’ll be using that money to invest in an appreciating asset, like education, home improvements, or your financial security. On the flipside, it might not be the best choice if there isn’t a clear financial benefit.
Need some help talking through your options? We’re here to help. Our Mortgage Experts are non-commissioned, so they’re always looking out for your best financial interests, not their own. Schedule a free consultation here.