Point of Interest
Cash-out refinancing allows you to convert the equity in your home to a lump sum of cash by extending your mortgage.
A cash-out refinance can help fund major expenses that would otherwise take years of saving. Here are the pros and cons of a cash-out refinance.
A cash-out refinance allows homeowners to use their home equity for immediate access to cash, tax-free! It can be an excellent option for homeowners looking for ways to fund a large purchase like a renovation.
Historically, refinancing activity picks up when interest rates fall. In response to historically low-interest rates, the average 30-year fixed-rate mortgage has fallen from 3.77% to 3.02% year-over-year (as of July 2020), leading many homeowners to refinance their mortgage. According to CoreLogic, refinance loan originations increased by 59% in 2019.
Interest rates are expected to remain low for the foreseeable future. If you bought your home in the last 10 years or so, now might be a good time to review your refinance options.
What is a cash-out refinance?
Refinancing means paying off an existing loan and replacing it with a new one at different terms. A cash-out refinance works by refinancing your remaining balance for a higher dollar amount, then taking the difference between your new mortgage balance and the original balance in cash, tax-free. You convert your accumulated home equity into cash in exchange for extending your mortgage repayment period.
A cash-out refinance is most appropriate to fund major expenses that would otherwise take years of saving up to fund. If you’ve owned your home for a few years and plan to stay for a few more, a cash-out refinance may be a great option to fund a remodel or renovation. You can also use the proceeds to consolidate debt, pay off student loans or pay tuition, and more. It’s cash, so you have the flexibility to use it as you see fit!
Pros of a cash-out refinance
A cash-out refinance can make more sense than using credit cards or taking out a personal loan. Here are some of the benefits:
Lower interest rate: If you can reduce your current interest rate by 1% or more, it’s usually a good idea to look into refinancing your mortgage. Mortgage rates benchmark to the underlying interest rate, and rates have been historically low for years. There’s a very good chance the interest rate you could obtain now is lower than your current rate.
Tip: Find the best cash-out refinance rates
Tax-advantaged home improvements: Remodeling your home can increase the home’s resale value. The average payback in a home’s resale value is estimated to be 56-75% of the cost of remodeling. That means that a $50,000 remodel could add $28,000 to $37,500 of value to your home. Additionally, if you use the funds to buy, build or improve a home, the IRS allows you to deduct mortgage interest paid on loan principle, up to $1 million for a couple ($500,000 for a single person).
Consolidate debt: Generally, mortgage interest rates are lower than credit card interest rates. You can use the proceeds from the cash-out refinance to pay off any high-balance, high-interest credit cards. Note that mortgage interest isn’t deductible if used to repay credit cards.
Cons of a cash-out refinance
There are a few things to consider before pursuing a cash-out refinance.
Potential PMI risk: If you use more than 80% of your home’s value, you may have private mortgage insurance (“PMI”) added to your payment. The PMI rate is calculated based on the loan amount as well as other factors like creditworthiness and debt-to-income ratio. It can be as little as 0.55% or as high as 2.25% per year.
High closing costs: You pay closing costs on the entire loan amount. If you owe $200,000 on your mortgage, then use a cash-out refinance to borrow an additional $100,000, you pay closing costs on the entire $300,000. Typically, closing costs are 3%-6% of the mortgage amount. Cash-out refinances also require an independent appraisal of your home. An appraiser costs around $300 to $400, depending on the size of your home.
Foreclosure risk: Secured debt (also known as “collateralized” debt) is money you borrow using a physical asset as collateral. That way, if you renege on the payment, the lender can take the physical asset you used to borrow the money in the first place. Interest rates are usually lower for secured debt than unsecured debt. Generally, you want to avoid using secured debt (your home) to pay off unsecured debt (like credit cards) because you might risk foreclosure if you don’t establish stronger financial habits.
When to consider a cash-out refinance
A cash-out refinance is a full restructure of your existing mortgage under new terms. It may be worth going through the process if you need a large sum of money and don’t plan to move soon. Otherwise, if you need cash but don’t plan on staying in the home for very long, a home equity line of credit (“HELOC”) or home equity loan may be more appropriate. Closing costs for these loans are lower than a cash-out refinance as you’re borrowing money from your equity rather than refinancing your entire mortgage.
Examples of cash-out refinance scenarios
Here are some situations where a cash-out refinance could be appropriate:
- You plan to buy, build, or improve a home, and you have 20% equity or higher. That way, you can deduct the interest, avoid paying PMI and improve the home’s resale value
- You want to pay off high-interest credit cards with a high revolving balance.
- You plan to pay off student loans or pay a child’s tuition.
- You want to invest the proceeds.
Tip: Using the proceeds to pay off credit cards with a high revolving balance can leave the door open to enabling bad financial habits.
How does a cash-out refinance work?
Let’s say your home is worth $200,000: you’ve built up $100,000 equity and $100,000 balance left on your loan. You could cash-out refinance to increase your mortgage from $100,000 to $150,000. You receive the difference between your old balance and new balance in cash — $50,000 — tax-free.
Is cash-out refinance a good idea?
It depends on your creditworthiness and your financial condition. If you plan to build, buy, or improve a home and have built up at least 20% equity in your home, a cash-out refinance may make sense.
How much can I cash-out refinance?
Lending thresholds vary by company. Generally, you can take up to 80% loan-to-value without paying PMI.
The final word
Saving up to buy your home was likely one of the biggest investments you’ve made so far. It’s essential to keep your home up-to-date with the necessary repairs and to make sure it can meet your family’s needs. A cash-out refinance can help pay for renovations, consolidate debt, or meet any other large expenses.