The cash-out refinance has become a common mortgage type. Homeowners use the equity in their homes to obtain funds for many reasons. But is it always a good thing to do?
Sometimes yes, sometimes no. Let’s look at the pros and cons of a cash-out refinance.
The Pros of a Cash-out Refinance
Borrowing at a low interest rate
You may be lucky enough to get a preferred credit card rate through your local bank or credit union. They may give you an APR of something like 12.99%. If you’re not that lucky, you’re paying a lot more. In fact, the average rate on credit cards just reached 16.75% APR. And even in this time of very low interest rates, it’s not at all unusual for credit cards to carry rates well over 20%.
The situation is similar with personal loans offered by online peer-to-peer lenders. They typically advertise rates “between” 5.99% and 36.00%. That’s a wide range, and it’s unlikely you’ll get anything like 5.99%. Low double-digit interest rates may be the best you can hope for.
But if you do a cash-out refinance on your home, you may be able to get an interest rate as low as 4% or 5%.
Larger loan amounts than credit cards
Typically, credit cards will come with a credit line of between $5,000 and $10,000. Personal loans from peer-to-peer lenders usually max out at $35,000. But if you do a cash-out refinance on your home, you can get a loan of $50,000, $100,000 or more. It all depends on how much equity you have in your home.
This is why a cash-out refinance is a superior way to consolidate debt. A larger loan amount may enable you to pay off multiple, higher-interest rate debts. It’s even possible to pay off other debts, like car loans and student loans.
Low Monthly Payments
The combination of a lower interest rate and a loan term as long as 30 years will result in one, overall lower monthly payment.
Let’s say you have three credit cards, a medical bill, your mortgage, and a car payment all being paid monthly. Well, if you were to complete a cash-out refinance, you could potentially use the cash you receive to pay off the credit cards, medical bills, and car payment in one fell swoop. This would leave you with one, simple, stable, monthly payment – your mortgage, and possibly some extra cash in your pocket too!
Only by doing a cash-out refinance on your home can you consolidate so many obligations into a single and likely lower monthly payment.
Use the proceeds for any purpose
Though the proceeds of a cash-out refinance are commonly used to improve your home, they can be used for just about any purpose. They are frequently used for debt consolidation, but can also be used for other purposes.
Those can include borrowing money against the home to purchase a car, finance a child’s college education, or even to invest in other real estate.
A large potential loan amount, as well as a lower overall monthly payment, makes a cash-out refinance a natural way to finance a wide variety of projects and purposes.
The Cons of a Cash-out Refinance
Putting your home at risk
Any kind of financing on your home represents a risk. The most significant risk is that you will be unable to make the monthly mortgage payment, and lose the house in foreclosure.
Technically speaking, this is a possible outcome with a loan of any size. But the larger the loan, and the smaller the equity position, the greater the risk.
Increasing your monthly house payment
In the example above, we showed an excellent demonstration of how a cash-out refinance can reduce your overall monthly obligations. But it’s possible that a cash-out refinance can also increase your monthly mortgage payment. It’s possible if the interest rate on the cash-out refinance is higher than the original mortgage rate.
For example, let’s say the rate on your original mortgage amount of $200,000 was 4.25%, with a monthly payment of $983. You paid the balance down to $150,000, and now you want to take $50,000 cash out. If the new mortgage – at $200,000 – has an interest rate of 5.00%, the monthly payment will rise to $1,074.
It’s probably still a good trade-off if you’re paying off non-housing debt. But the end result is that your monthly payment is rising by $91.
Reducing your home equity
A cash-out refinance is based on the equity you have in your home. Anytime you increase the mortgage indebtedness on your home, the amount of home-equity declines.
If your home is worth $250,000, and you have a $150,000 mortgage on it, you have $100,000 in home equity. But if you do a $200,000 refinance for cash out, the equity drops to $50,000.
Even if the cash out proceeds are being used to pay off other debt obligations and reduce your overall monthly expenses, the increase in the mortgage debt amount will increase the length of time to pay off the loan, so that you can own your home free and clear.
If your goal in doing a cash-out refinance is to minimize the interest rate and monthly payment, you’ll have to pay closing costs. Since they typically run about 2% of the loan amount, you’ll pay about $4,000 on a new mortgage of $200,000. The closing costs will either have to be paid out of personal funds or out of the loan proceeds of the cash-out refinance.
Of course, you can finance the closing costs by increasing the interest rate you’ll pay on the loan. This is what is referred to as lender financing, and it’s common practice with refinancing.
Final Thoughts on the Pros and Cons of a Cash-out Refinance
As you can see from everything listed above, there are advantages and disadvantages to doing a cash-out refinance. Carefully weigh out the reasons why you want to do a cash-out refinance while considering the drawbacks.
However it’s done, a cash-out refinance should always be structured in a way that will provide you with tangible and long-term benefits. Your mortgage loan officer will be able to show you the available options so you can make an informed decision.