Cash-out refinancing, which involves refinancing your existing mortgage for more than you owe so you can cash out your equity, has skyrocketed in recent years. In fact, at the end of 2018, “cash-out” borrowers increasing their loan balance by at least 5% made up 83% of all conventional refinance loans, according to Freddie Mac’s Quarterly Report. That’s the highest share cash-out refinancing had seen since 2007.
With cash-out refinancing on the up and up, you may wonder if it’s a financial move you should make. Before you sign on the dotted line, though, it’s important to know what cash-out refinancing is, why it’s growing in popularity and the potential risks involved with this type of loan product.
What is cash-out refinancing?
Cash-out refinancing is a form of mortgage refinancing. With cash-out refinancing, you take out a new loan that is larger than your existing loan, pay off your existing mortgage and cash out the difference. Approval for this type of refinancing is based on how much equity you have in your home. Lenders generally let you borrow up to 80% of your home’s value unless you are doing home improvements. In that case, you may be able to borrow up to 100%.
A cash-out refinance is different from a traditional mortgage refinance because rather than simply replacing your mortgage with a new one in the amount of the remaining balance, you are also liquidating a portion of your available equity. It can be a risky proposition, and it begs the answer to the question of when it is a good idea to take advantage of cash-out refinancing.
“One time it makes sense to do a cash-out refinance is to get money for home repairs. It’s cheaper to borrow money from your equity than to get another type of loan — and doing home repairs is helping you to maintain your home’s value, not to mention making it more livable for you,” Guy Troxler, chief operating officer for FedHome Loan Centers, said. “Another time a refinance might make sense is for the purposes of loan consolidation. If you have some high-interest loans that you want to refinance at a lower interest rate, then the cash-out refinance might help with that.”
Proceeds should be used to help your long term financial strategy rather than frivolous expenses.
How cash-out refinancing is making a comeback
The resurgence of cash-out refinance loans is the result of a perfect storm of rising home values, record high tappable equity and falling interest rates, according to Black Knight’s Mortgage Monitor Report. Tappable equity hit an all-time high of $6.3 trillion in Q2 of 2019, and a total of 45 million homeowners had an average of $140,000 in equity available before they’d reached the 80% loan-to-value.
It can be tempting to take a large sum of cash that becomes available to you at an affordable cost, and many homeowners are doing just that. As of December 2019, cash-out refinances saw a 24% increase year over year and made up over half of all refinance loans.
Why is cash-out refinancing so popular?
Cash-out refinancing has spiked in popularity over the past few years, mainly because homeowners are recognizing the opportunity to borrow a lump sum of cash with a low interest rate. One of the most common uses of the funds is to pay off high interest credit card debt. When done correctly, this can be a beneficial move, given that most credit cards charge interest rates between 14% and 25% or more, while mortgage lenders are offering rates between 3% and 4%. Borrowers that use their cash-out refinance to pay off debt can save hundreds or even thousands in interest. In addition to debt consolidation, other common uses for cash-out refinancing funds include home renovations and improvements, college expenses, additional properties and cash reserves.
Dangers of cash-out refinancing
While a cash-out refinance is appealing to many homeowners and can be advantageous if the circumstances are right, there are also serious risks involved that you should consider. One major potential issue comes from the fact that your home is the collateral for your mortgage, so you’re at risk of losing it if you can’t make the payments.
“The biggest risk involved with a cash-out refinance is that if you’ve cashed out too much equity and the value of your home drops, you could end up over-leveraged,” Troxler said.
This was a huge issue back in 2008 when the housing bubble collapsed. Millions of homes rose in value so the owners cashed out the equity. When the housing bubble popped and the economy crashed, many homeowners were left with mortgages that were far more expensive than they could afford, causing them to default on their loans and lose their houses.
“Another concern is that if you only have a couple of years left on your mortgage, doing a refinance can be kind of like turning back the clock on the payments you’ve made,” says Troxler, “You can mitigate that a bit by trying to get a low term on the refinance.”
It’s also important to note that if your current mortgage has a really low rate you might have to accept a higher rate in order to refinance, which can cost you more than its worth in the long run. To ensure a cash-out refinance is worth it, make sure to run all the numbers and compare various options.
Alternatives to cash-out refinancing
If you need to borrow a large amount but aren’t sure if a cash-out refinance is the right choice, there are a few alternatives to consider, including:
Unsecured personal loans are loans you may be able to borrow depending on your creditworthiness and financial picture. This type of loan can range from $1,000 up to $100,000 depending on the lender. These often come with higher interest rates than loans secured by home equity, but they don’t put your home at risk. Further, if you have great to excellent credit, you can likely get very competitive rates and terms.
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Home equity line of credit (HELOC)
A home equity line of credit (HELOC) is a line of credit for a percentage of the equity you’ve built in your home — usually 85% max — and is secured by your home. A HELOC offers you access to a revolving line of credit for a specific draw period, and you can use that line of credit multiple times. Paying it back will restore your full limit, and you’ll only be required to pay interest on what you borrow. After the draw period is over, the balance will typically move over to a repayment period, in which you will pay back the balance but can no longer draw on the HELOC.
The advantages of a HELOC include the fact that you only pay compounded interest on the amount you withdraw from your credit line versus the whole loan amount. Additionally, many lenders give you the option for interest-only payments during the draw period.
This can be a good option if you want to leave your original mortgage in place while cashing out your available equity on an as-needed basis.
“A HELOC can give you easier access to funds than a cash-out refinance, without having to give up the low-interest rate on your current mortgage, (assuming your rate is lower than the rate currently available,” Troxler said.
The downside to that equation is that it puts a second lien on your property, separate from your original mortgage, which puts your house at risk in case you default on the money you borrowed. HELOCs also generally come with adjustable rates, which can cause your payment amounts to increase over time.
Home equity loan, or second mortgage
A second mortgage is a lump sum loan used to borrow against the equity in your house. It differs from a cash-out refinance because it is a separate loan that puts a second lien on your home and leaves your original mortgage intact. This can be a good option if you want to keep your original mortgage as is and need a large sum all at once. The downside to second mortgages is that they often come with adjustable interest rates which can rise over time. They also put your home at risk if you default.
The bottom line
Cash-out refinancing is on the rise again, which does set off some alarms because of the damage done in the not-so-distant past. Before jumping on the bandwagon, be sure to think through the risks and benefits. There are pros and cons to every type of borrowing. Any loan backed by your home’s equity puts it on the line if you default. However, that security for the lender also helps you to land low interest rates and fees. Personal loans are a good alternative to consider as don’t put your home at risk but will only be comparable (and available) if you have strong credit and financial profiles.
When deciding between the home equity loan options, first decide if you can match or beat the rate and terms of your original mortgage. If not, a HELOC will be better if you don’t need all the funds at once while a second mortgage is better if you need a lump sum. A cash-out refinance is advantageous if the overall cost will be lower than the alternatives.