Benefits and Drawbacks of a Cash-out Refinance
A cash-out refinance enables homeowners to tap into their home equity and receive a lump sum of cash. This money can be utilized for various purposes such as debt consolidation, home renovations, education expenses, business ventures, real estate investments, or significant purchases. However, before proceeding with a cash-out refinance, it’s essential to carefully evaluate both its benefits and drawbacks to determine if it aligns with your financial objectives.
What is a cash-out refinance?
In a cash-out refinance, you trade your current mortgage for a new, larger loan. This fresh loan covers the original mortgage and provides extra funds sourced from your home’s equity.
Many lenders offer cash-out refinancing options allowing you to tap into up to 80 or 85 percent of your home’s value. However, the specific amount could vary based on factors such as your creditworthiness, property type, and existing mortgage terms. Typically, lenders mandate that you maintain a minimum of 15 to 20 percent equity in your home after the refinance, although exceptions exist. Consequently, if you recently purchased a home with a low-down payment loan, you may not qualify for a cash-out refinance.
Cash-out refinance pros and cons
Consider both the advantages and disadvantages of a cash-out refinance before deciding if this mortgage refinancing approach aligns with your financial goals.
Cash-out refinance pros
- Access to a substantial sum: One significant advantage of a cash-out refinance is the ability to access the money you need by tapping into the home equity you’ve already built.
- Lower interest rates: Compared to credit cards and personal loans, a cash-out refinance often comes with a lower interest rate, potentially saving you money on interest payments over time.
- Stable payments: Opting for a new fixed-rate loan through a cash-out refinance means your monthly principal and interest payments remain consistent. This contrasts with home equity lines of credit (HELOCs), which typically feature variable rates.
- Tax deductions: You may be eligible to deduct the interest paid on the cash you withdraw from your taxes, provided you use the funds for qualified home improvements.
- Credit score enhancement potential: By using a cash-out refinance to consolidate higher-interest debt, there’s a chance your credit score could see improvement over time.
Cash-out refinance cons
- Increased debt: With a larger loan amount, your overall debt burden rises, regardless of how close you were to paying off your original mortgage.
- Debt postponement: If you’re using the cash-out to settle high-interest debt, ensure you’ve tackled the underlying spending issues. Otherwise, you may perpetuate a cycle of debt.
- Closing costs: Similar to your initial mortgage, refinancing incurs closing expenses. However, these fees are generally lower than those for home purchases.
- Foreclosure risk: Your home serves as collateral for the cash-out refinance. Failure to repay the loan could result in foreclosure, leading to the loss of your home.
Should I get a cash-out refinance?
A cash-out refinance could be advantageous if you secure a lower interest rate than your current one and plan to utilize the funds for financial enhancement or property improvement. This might involve upgrading your home to increase its value or consolidating high-interest debt to ease your financial strain.
However, if you cannot attain a reduced interest rate, especially if you opt for a new 30-year loan, a cash-out refinance may not be the most prudent choice. Moreover, if you anticipate selling your home shortly, a cash-out refinance may not be advisable, as you’ll be required to settle the higher balance upon closing.
Consider a cash-out refinance in the following scenarios:
- Lower interest rate: When you can secure a reduced interest rate on your mortgage.
- Improved credit score: When using the proceeds to pay off or consolidate debt can enhance your credit score.
- Tax deduction: When planning home renovations that qualify for a tax deduction on your federal tax return.
- More competitive borrowing cost: When the borrowing cost is lower compared to other loan types, such as a home equity loan or a personal loan.
Alternatives to a cash-out refinance
If a cash-out refinance isn’t suitable for your needs, there are alternative options available that allow you to leverage your home’s equity:
- Home equity loan: Home equity loans offer a lump sum payment similar to a cash-out refinance. You repay the borrowed funds in fixed installments, typically at a lower fixed interest rate compared to various other consumer lending options.
- HELOC: A home equity line of credit (HELOC) operates as a revolving credit line, akin to a credit card. With a HELOC, you have the flexibility to borrow what you require, repay the borrowed amount, and then borrow again as needed. HELOCs typically feature a specific draw period during which you can access funds as necessary. Once the draw period concludes, you repay the outstanding balance in installments.
Both of these alternatives are often quicker and less costly to obtain than a cash-out refinance. However, it’s important to note that they utilize your home as collateral and may entail higher interest rates compared to refinancing.