Cash-out refinancing allows homeowners to tap into their home equity by replacing their existing mortgage with a larger loan. The funds received from increasing your mortgage balance can be used for any purpose. With home values up in many markets, cash-out refinancing has grown in popularity. However, it’s not the right choice for everyone. This guide will walk through the pros and cons of cash-out refinancing to help you decide if it aligns with your financial situation and goals.
How Cash-Out Refinances Work
A cash-out refinance replaces your current mortgage with a new, larger loan secured by your home equity. Your new loan amount covers the remaining principal on your existing mortgage, plus additional funds given to you in cash at closing.
For example, if you have a $200,000 balance left on your mortgage and your home is now worth $300,000, you may qualify for a new loan up to 80% of your home’s value, or $240,000. This would pay off your current $200,000 balance and provide $40,000 cash in hand at closing.
Cash-out refinancing works best when interest rates are low and you’ve built up substantial equity. The larger your loan amount compared to your home value, the higher your interest rate will be.
Pros of Cash-Out Refinancing
There are many potential benefits that make cash-out refinancing attractive:
Access equity without selling: Cash-out refinancing lets you tap into your home equity without selling or getting a home equity loan. If your home value has grown, a cash-out refi provides liquid funds.
Consolidate higher interest debt: The cash can be used to pay off credit cards, personal loans, or other debts with high interest rates. Folding this debt into your lower mortgage rate saves on interest.
Fund home improvements: Major renovations and upgrades can be financed into your new mortgage at a lower rate than other financing options.
Manage rental properties: Landlords can access equity to buy more investment properties or fund repairs on rentals. The interest is tax deductible.
Pay for college: Large upcoming expenses like college tuition can be prepaid with cash from a refinance.
Buy investment assets: Some use cash-out refis to secure financing for investments like real estate or a business.
Lower monthly payments: In some cases, refinancing at a lower rate can lower monthly costs, even with a larger mortgage balance.
If your goal aligns with one of these uses, a cash-out refi can provide an inexpensive way to access capital.
Cons of Cash-Out Refinancing
There are also some potential drawbacks to consider:
Closing costs: Upfront closing costs range from 2-5% of the total loan amount. This covers origination, appraisal, title insurance, and other fees.
Higher monthly payments: Unless you refinance at a significantly lower rate, your monthly costs will increase due to higher principal.
Interest expense: You’ll pay more in interest over the life of the loan due to higher principal and longer term.
Lower equity & ownership: Your loan-to-value ratio rises, which lowers the equity stake in your home.
Risk of overspending: Having a lump of cash on hand can lead some borrowers to overspend rather than use funds responsibly.
Possibility of declining home value: If the housing market shifts, you may end up owing more than your home is worth.
Difficulty qualifying if circumstances change: Loss of income or increased debt can make qualifying for the refinance challenging.
For those with excellent credit and secure finances, these risks may be manageable. But for borrowers already stretched thin, they can be dangerous pitfalls.
Deciding if a Cash-Out Refinance is Right For You
Cash-out refinancing is a financial tool that can be used strategically or lead borrowers into grave hardship. Consider the following factors to gauge if it aligns with your situation:
Your equity position: The more equity you currently have in your home, the lower your risk when refinancing into a larger loan. Be cautious if you have less than 20% equity.
Your credit score and income: Qualifying for a competitive rate requires a strong credit score of at least 700 and stable income. Low scores or unsteady jobs add risk.
The reason you need cash: Be sure your reasons for refinancing justify increasing your total debt load. Avoid tapping equity for unnecessary purchases.
Your future plans for the home: If you may sell soon, the benefits of refinancing could be short-lived. Locking in a lower rate long-term provides more upside.
Your comfort with debt: Only borrowers who are disciplined about debts should utilize this strategy. If you tend to overspend, it can do more harm than good.
Market conditions: When rates are low and home values in your area are rising, risks are reduced. Volatile markets make cash-out refinancing riskier.
Taking a holistic look at these factors will reveal whether cash-out refinancing is likely to benefit your situation or become a liability.
Alternatives to Cash-Out Refinancing
If upon evaluation a cash-out refi seems too risky for your needs, here are a few alternatives to consider:
Home equity loan or HELOC: These loans allow you to borrow against home equity without refinancing your entire mortgage. You can access funds as needed rather than getting a lump sum upfront.
Cash-in refinance: Also called a rate-and-term refinance, this lets you refinance into a lower rate without taking cash out. You keep the same loan balance but lower payments.
Personal loan: An unsecured personal loan from a bank or online lender lets you borrow cash for any use and pay it back over time. Rates are higher but you don’t put your home at risk as collateral.
401(k) or IRA withdrawals: For short-term needs, you may be able to take a loan from your retirement savings without penalty. This should be done cautiously to avoid jeopardizing your nest egg.
Depending on your specific situation, one of these options may allow you to affordably access funds needed for renovations, debt payoff, or other costs in a safer manner than cash-out refinancing.
Key Takeaways: Is a Cash-Out Refinance Right for You?
Cash-out refinancing provides homeowners with an inexpensive way to unlock their home equity for major expenses, debt consolidation, and more. However, this strategy also comes with risks like closing costs, increased debt, and the potential for overspending. Before applying for a cash-out refinance, look holistically at your financial situation to determine if it is the right move.
For borrowers with substantial home equity, excellent investment property loans, and financial discipline, cash-out refinancing can be a strategic tool. But proceed with caution—and explore alternatives like home equity loans—if your circumstances make this option too risky. Analyze the pros and cons and make an informed decision before using your home equity to finance other financial needs.
