Should You Consider a Cash-Out Refinance?

A cash-out refinance is like squeezing a little extra money out of your home’s stored-up value, or equity. Simply put, you refinance your existing mortgage for more than you currently owe on the house, and keep the difference in cash.

If you’re careful about how you spend that money and you’re a super-sleuth when it comes to finding great interest rates, a cash-out refinance might be a good option for you. The best time to take advantage of this type of loan is when you want to refinance your mortgage to a lower interest rate, and you’d like some extra money to cover home improvements, college tuition, or some other important expense.

It doesn’t make sense to refinance a higher amount at the same or higher interest rate, however. And it’s crucial to remember that a cash-out refinance can have dire consequences if not used carefully. You probably heard about people “using their homes as ATMs” during the housing boom of the early 2000s; using a cash-out refinance to cover more frivolous or unsustainable spending is a recipe for financial disaster that can lead to suffocating debt or even foreclosure.

Cash-Out Refinance vs. Home Equity Loan

While both a cash-out refinance and a home equity loan help you take advantage of the equity you’ve built up in your home, they differ in a few key ways.

With a cash-out refinance, you’re replacing your existing mortgage loan with another (larger) single loan. You’ll still have one payment each month, and the loan term will likely be a long one (e.g., 15 to 30 years). As with your previous mortgage, you’ll be on the hook for closing costs and a mountain of paperwork.

Home equity loans, on the other hand, create an additional mortgage, putting a second position lien on your property and creating a second monthly payment to keep track of. Also, because you’re not making changes to your existing mortgage, you can’t improve the interest rate as you can with a cash-out refinance. Finally, a home equity loan usually requires a bit less paperwork and fewer fees, and is commonly spread out over a shorter term, such as five to 15 years.

Should You Consider a Cash-Out Refinance?

There are two main questions to ask yourself when considering a cash-out refinance. First, are you sure you can get a low enough interest rate to make it worthwhile? As with any mortgage refinance, shop around for the best available mortgage rates, and use a refinance calculator to determine how much lower your rate needs to be to offset the associated closing costs.

That brings us to the second question: Are you willing to pay closing costs? While a home equity loan doesn’t typically require closing costs, a cash-out refinance does, just like any other mortgage product, and they can range from a few hundred to a few thousand dollars.

Use a refinance calculator to see how long it will take to reach your break-even point: when the monthly savings from the refinance are enough to cover the estimated closing costs. Depending on the fees and how much lower your new rate is, this might be months or years, but a refinance only makes sense if you plan to stay in your house longer than that.

Finally, remember that while extending your loan term can lower your monthly payment, it can add years and thousands of dollars in interest to the life of your loan. If you’ve got 25 years left on your mortgage, it can be tempting to refinance it into a new 30-year loan to lower your monthly payment and pocket even more cash; but that can leave you paying many thousands of dollars in extra interest over the years, and still saddled with a mortgage when you’d have otherwise been debt-free.

Experts recommend that if you do choose a cash-out refinance, you use the extra cash for sensible reasons. Remember that you still have to pay back the money you’ve cashed out, so have a plan in place of how it will be spent wisely. That means no splashy three-week vacations in the Mediterranean. However, investing in your family or putting the money back into your home are typically worthwhile uses: have the house repainted, help your child with college payments, or get that kitchen remodel you’ve always wanted.

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