If you’re a homeowner, you likely remember being privy to the reflection and experience of all those who came before. In fact, you were probably told time and again to use wisdom and prudence as closing day arrived, since buying a home would be among the largest purchases you would likely ever make.
It turns out that refinancing a mortgage is also one of the most important financial decisions people can make. That’s because borrowers (to some extent) choose the interest rate differential at which to refinance. The key is realizing when that differential has been reached and when you’re getting the best deal possible, then taking the steps to refinance before rates change again.
The wild card in the equation is when you chose to pursue a cash-out refinance. While there can be friction to such a deal — at least more so than a straight refinance — financially sophisticated borrowers would be remiss not to consider the pros and cons of leveraging their home equity when the time is right.
What Is a Cash-Out Refinance?
According to the Wall Street Journal, many homeowners who need cash are taking it out of their properties. Not with a home equity loan or a line of credit, but through a cash-out refinance. But the name shouldn’t put dollar signs in your dreams or conjure up the image of an ATM.
Where a straight refinance involves lowering the interest rate and getting better terms on your loan, a cash-out refinance means that you’re borrowing more money in your new mortgage than you owe on your current one.
Here’s the math:
Let’s say you have a current mortgage principal of $200,000. Between what you’ve already paid down on your loan combined with rising home values, your property is actually worth $350,000. If you need cash, have good credit, and can meet some other requirements, you might be able to negotiate a cash-out refinance where your new mortgage is worth $275,000. Minus transaction costs (more on those below), you walk away with a new mortgage and $75,000 in cash at closing.
It sounds easy enough, right?
The Pros of a Cash-Out Refinance
Any mortgage lender will tell you that an obvious benefit to a cash-out refinance is just that — the ability to tap your home equity and cash out the difference on your brand new loan. But according to SmartAsset, other benefits include:
- Not having to sell your home. Home equity may be the biggest advantage you have if you need cash and there are only two options: sell … or treat your home like a small money mill.
- You can use the money for almost anything you want. Plan to pay off debt? Make some home renovations? Go on a big vacation? You can do what you want with the cash, though you should use sound financial planning instead of digging yourself further into debt.
- No taxes. You won’t have to pay Uncle Sam on the amount of equity you cash out, and you can still write off the interest payment on the mortgage.
- A lower interest rate — when compared to a home equity line of credit (HELOC) or home equity loan.
On the flip side…
The Cons of a Cash-Out Refinance
According to The Journal of Fixed Income, the poor performance of cash-out refis proved to be an important contributing factor to the 2008 financial crisis. In the wake of the recession, when U.S. homeowners reportedly lost close to $6 trillion in equity, cash-out refinancing has been more difficult to obtain (even if it does bolster consumer spending).
The folks at MarketWatch are quick to point out that the cons of a cash-out refinance include:
- You lose equity in your home, and it’s not guaranteed to come back. Just remember that once you commit to a cash-out refi, you’re walking away with the value of your home in dollar form. That means if you have to sell a few years down the road, you’ll leave at closing with a lot less money.
- You could end up owing more than the home is worth. To the point above, have you ever heard a mortgage specialist use the term ‘underwater’ in reference to a property? While rules exist on how much equity a homeowner can leverage, you run the risk that the value of your home could fall even farther, compounding the loss.
- You’ll still pay closing costs. Just like when you purchased your home, you have to pay closing costs again when you refinance. That can include an application fee, appraisal fees, attorney fees, and more. In fact, if you pay a few thousand dollars in fees to refinance and you only needed a small lump sum in cash-out, you might not break even. Plus, you could end up on the hook for private mortgage insurance (PMI) again.
- You’ll likely pay a higher interest rate. When you choose a cash-out refinance, you completely wipe away your original mortgage and replace it with a brand new loan. That changes the money payments, and likely will mean a higher interest rate. Remember, the more money you borrow, the more interest you pay.
Other Cash-Out Refi Rules and Thoughts
Comparing the two lists above might lead to the conclusion that a cash-out refinance just isn’t worth it. But if you’re still unsure, it just means you’ll need to do a little more homework on the rules to understand how they’ll apply in your situation.
Simply put, the rules of a cash-out refi will vary by lender. Almost all of them will require that you wait at least 12 months before applying for a cash-out refinance. That means you’ll need to have owned your home for a period of one year before you’re able to take advantage of any equity in the property. Because cash-out refis also adhere to a strict loan-to-value (LTV) ratio, you probably won’t be able to complete a cash-out refi with more than an 80% LTV.
None of this makes a cash-out refi a bad idea. If you’re well past the so-called ‘seasoning’ period of your loan (that 12-month window) and interest rates have dropped significantly, you can use your cash-out refi to pay off high-interest debt (in other words, you can use it to your advantage).
If interest rates have dropped significantly and you know you’ll be staying put in your home, a cash-out refi can also make sense.
As of March 2020, the average 30-year fixed mortgage rate was around 3.55%. A cash-out refinance would yield a better rate, if you bought your home when the 30-year fixed was higher (at least a full percentage point, or more).
The bottom line is that cash-out refis aren’t the best option for everyone, and you should compare the alternatives. A lender may advise that a HELOC may be more flexible and cheaper, depending on your situation. But if your goal is fixed-rate debt consolidation, a cash-out refi is certainly worth a look.
- Americans are Taking Cash Out of Their Homes – And It Is Costing Them, The Wall Street Journal. Accessed at https://www.wsj.com/articles/americans-are-taking-cash-out-of-their-homesand-it-is-costing-them-11577529000
- What is a Cash-Out Refinance? SmartAsset. Accessed at https://smartasset.com/refinance/what-is-a-cash-out-refinance
- What Fueled the Financial Crisis? An Analysis of the Performance of Purchase and Refinance Loans, The Journal of Fixed Income. Accessed at https://jfi.pm-research.com/content/28/1/27
- Should You Do a Cash-Out Refinance? The Pros and Cons. MarketWatch. Accessed at https://www.marketwatch.com/story/should-you-do-a-cash-out-refinance-the-pros-and-cons-2019-10-23
- A Homeowner’s Guide to a Cash-Out Refinance, RocketMortgage. Accessed at https://www.rocketmortgage.com/learn/cash-out-refinance
- Today’s Mortgage and Refinance Rates, BankRate. Accessed at https://www.bankrate.com/mortgage.aspx