Need a large chunk of change to start a business, pay down debt, or finance your child’s college tuition? If your home value has increased, one option is to use a cash-out refinance. Anything that talks about "cashing out" sure sounds good, right? But before you sign up, let's discuss the cash-out refinance rules—and the real-world pros and cons.
A cash-out refinance is the process of refinancing your mortgage for more than you currently owe and taking the difference in cash. You are in effect “cashing out” some of the equity in your home to pay for something else. Your new loan will be the amount you still owe on your mortgage plus the cash you wanted to take out.
For example, say you had a $300,000 loan, on which you still owed $200,000. That would mean you had $100,000 in equity in your house. Maybe you wanted to pay down some credit card debt, so you cashed out $25,000 of that equity, and got a new mortgage for $225,000, to replace your existing $200,000 loan.
Cash-out refinance vs. HELOC
You might be thinking, "Hold on! A cash-out refinance sounds more than a little like a home equity line of credit!" Here’s how it differs: A home equity line of credit, or HELOC, is a second loan on top of your first one, while a cash-out refinance actually replaces your existing mortgage.
So in our scenario above, if you used a cash-out refinance, you would end up with a completely new loan for $225,000. If you got a HELOC, it would keep your $200,000 existing loan and then give you a second loan of $25,000.
Benefits of a cash-out refinance
Because it’s part of a mortgage, the money you take as cash will typically have a better interest rate than if you were to use a credit card to fund the same purchase. So, for example, if the interest rate on your credit card is 12%, but your mortgage interest rate is only 4%, you can save a bundle getting the cash from a refinance rather than putting the expense on your plastic.
You’ll also benefit from the mortgage tax deduction, adds Cheryll A. LeBlanc, a loan officer at Fairway Independent Mortgage Corporation in Holden, MA.
"I would look at a cash-out refinance if my client needed a lump sum of money, like $25,000 for a remodel that may improve their home value,” says LeBlanc. It’s an especially good option if you are intending to refinance anyway, particularly to take advantage of a lower interest rate.
Drawbacks of a cash-out refinance
If you are able to refinance to a lower interest rate, that could make a lot of sense. But if your interest rate was, say, 3.5% and today’s interest rate is 4.5%, you’d be refinancing your mortgage at a higher rate, which would cost you more money over the long run.
“If you already have a great rate on your mortgage, you could end up losing out if you refinance, and rates have risen from where yours was,” LeBlanc cautions.
Plus, you’ll have to pay closing costs, which average about 3% to 6% of your total loan.
Keep in mind that you'll also have to a pay closing cost on a HELOC, but it will only be on the amount of the HELOC. So in a worst-case scenario, 3% of a $25,000 HELOC is $750, whereas 3% of the new cash-out refinance amount of $225,000 is $6,750.
As for interest rates, when you tap a HELOC for $25,000, you are paying the higher interest rate only on the money you’re borrowing—the $25,000—rather than the whole mortgage plus the cash-out refinance of $225,000.
In addition, with a cash-out refinance, you could potentially be setting the clock back when you start a new 30-year loan, which sounds like an awfully long slog if you’ve already paid off a number of years on your mortgage loan.
LeBlanc adds that many financial advisers frown on tapping your home equity for purchases.
“If the reason for borrowing is a transient reason, such as a short business deal or tuition, I might recommend a HELOC that they can pay off and then use again when needed unless they were refinancing for a better rate anyway,” LeBlanc says.
Cash-out refinances are making bank in the industry
If those “cons” are making you think a cash-out refinance is a loser product, you might be interested to know that despite all of these apparent drawbacks, the technique is quite popular. In fact, nearly 42% of refinances in the third quarter of 2016 were cash-out refinances, according to Lynn Fisher, vice president of research and economics for the Mortgage Bankers Association.
Their popularity reflects the rise in equity that many homeowners have enjoyed over the past few years—proving that if they (mortgage lenders) build it, homeowners will come!