What is a Cash-Out Refinance?
When you have a home that is worth more than you owe on your mortgage, you have equity built up in your home. That difference between what your home is worth and what you owe on a mortgage is equity.
A cash-out refinance is a type of mortgage that allows you to refinance your existing mortgage and pull the equity you have built up in your home in the form of cash at the same time.
It wraps up the existing mortgage amount and the amount of cash or equity you pull out of your home into one new mortgage.
Cash-Out Refinance Pros
As is the case with almost anything in life, deciding to do a cash-out refinance has its advantages and disadvantages.
One of the biggest advantages is a cash-out refinance gives you the cash you need. You can use the cash for various reasons, such as renovating or putting an addition on your home, to make a purchase like a car or to pay for college expenses for one of your kids.
Since a cash-out refinance allows you to refinance your existing mortgage while simultaneously pulling your equity out in the form of cash, you can lower the interest rate on your mortgage. This is assuming that refinance interests are lower than the existing interest rate you have on your mortgage.
You can consolidate your debt with the cash that you pull out of your home. You can use the cash to pay off high interest credit cards, car loans or other high interest rate loans. Debt consolidation can help you decrease the amount of interest you are paying and combines multiple payments into one payment, which can make paying bills faster and easier. If you are paying off your credit cards, it reduces your credit utilization ratio. The reduction of your credit utilization ratio can help to boost your credit score.
Generally, the interest you pay on your mortgage is fully tax deductible. A cash-out refinance mortgage helps to maximize the tax deduction on your mortgage.
Cash-Out Refinance Cons
One of the biggest disadvantages of a cash-out refinance is that it increases your mortgage payment. Since you are increasing the amount of the mortgage by the amount of cash you’re taking out, it increases the total mortgage payment you’re going to have to make.
When you establish a mortgage of any kind, you’re putting your home up as collateral for the loan. A cash-out-refinance is no exception to this rule. You are using your home as collateral for your debt. So in the event that you don’t pay your mortgage, you’re at risk for foreclosure or losing your home.
When utilizing a cash-out refinance, you’re responsible for paying closing costs. Since it is a higher amount than the existing mortgage, the closing costs are going to cost more than when you established your original mortgage amount.
Another disadvantage of doing a cash-out refinance is that it reduces the amount of equity you have in your home. A cash-out refinance is a new mortgage, so it can mean new terms and conditions for the mortgage, which can extend the amount of time you have to pay on the loan and even change your interest rate. If refinance rates are higher than what you pay now, you’re going to pay more interest.
Cash-Out Refinance vs. Home Equity Loans
A cash-out refinance and a home equity loan are both ways to pull the equity in your home in the form of cash. Each type of loan has its pros and cons.
Both types of loans allow you to get the cash equity in a lump sum so you can start paying on the new mortgage amount right away. The main difference between a cash-out-refinance and a home equity loan is a cash-out refinance replaces your existing mortgage with a new mortgage.
A home equity loan can go in second lien position, which means you can leave your existing mortgage in place, but still access your cash equity. If you have a low interest rate on your first mortgage and refinance rates are higher, you might want to consider a home equity loan instead.
Another major difference is that a lender typically does not charge the borrower for closing costs on a home equity loan. The lender typically covers these costs for the borrower. This is different from a cash-out refinance, where the borrower is typically responsible for paying the closing costs.
Finally, it can be easier to qualify for a cash-out refinance than it is for a home equity loan. This is primarily because a lender prefers to be in first lien position rather than second lien position. In case of a foreclosure, first lien lenders get paid before a second lien lender.
The Bottom Line
A cash-out refinance can make sense if you can lower your interest rate and if you are putting the cash you take out of your home to good use. Paying off high interest rate debt or renovating your home are good ways to put your equity to good use.
Using the cash-out to renovate or put an addition on your home can even help you build equity in your home quickly.
Whether you choose a cash-out refinance or a home equity loan, you are putting your home up as collateral for the loan so use the money wisely.