Cash-out refinancing: Here’s how to know if it’s right for you

What is cash-out refinancing?

Cash-out refinancing is a type of mortgage refinancing where you borrow more money than you currently owe on your home, and receive the difference in cash. Essentially, you are replacing your existing mortgage with a new one that has a higher balance, and pocketing the difference between the old balance and the new one.

This type of refinancing can be a way to access the equity in your home, which is how much of your home’s value you’ve paid off. For example, if your home is worth $500,000 and you’ve paid off $250,000, then you have $250,000 of equity to access. The money can be used for a variety of purposes, such as making valuable home improvements, consolidating high-interest debt, or covering major expenses.

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How a cash-out refinance works

Just like other types of mortgage refinancing, a cash-out refinance replaces your existing home loan with a new one. Keep in mind that the new loan will have a higher balance than your existing mortgage. You can then receive the difference between your old mortgage amount and the new one as cash.

It’s important to note that lenders usually require you to leave at least 20% equity in your home, which limits the amount you can cash out.

Reasons to consider a cash-out refinance

There are several reasons why someone might consider cash-out refinancing. Some of the most common ones include:

• Home improvements: Cash-out refinancing can provide you with the funds needed to do renovations on your home, such as adding a new room, upgrading the kitchen or bathroom, or making major repairs. Debt consolidation: If you have high-interest debt, such as credit card debt, you can use cash-out refinancing to consolidate it into one lower-interest loan.
• Education expenses: Cash-out refinancing can be a way for you to fund education expenses for yourself or your children, including tuition, books, or other costs associated with attending college.
• Investment opportunities: You might want to use the funds from a cash-out refinance to invest in a rental property or a business venture. Emergency expenses: In some cases, cash-out refinancing can provide homeowners with access to money in the event of an emergency,) such as a medical issue, job loss, or unexpected home repair.

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Example of a cash-out refinance

Let's say you bought a house for $250,000 several years ago, and you took out a mortgage for $200,000. You've been paying your mortgage for several years and have now paid down $150,000 of the principal. Meanwhile, your home has appreciated in value to $350,000. This means you have $200,000 in equity in your home ($350,000 - $150,000).

You decide to apply for a cash-out refinance loan to access some of this equity. You apply for a new loan for $225,000, which is $75,000 more than your current mortgage balance of $150,000. The lender approves your loan and you receive the $75,000 in cash. You use $50,000 to pay off high-interest credit card debt and $25,000 to renovate your kitchen. Your new mortgage balance is now $225,000, and your monthly payments are higher, because you're now paying interest on the new loan amount.

While you've increased your mortgage debt and will pay more interest over the life of the loan, you've also been able to use the equity in your home to pay off debt and make home improvements, which could increase the value of your home in the long run.

Pros and cons of a cash-out refinance

Cash-out refinancing is one way for homeowners to get low-interest financing for big expenses. But it’s not without risks and drawbacks. Here’s a closer look at the pros and cons of cash-out refinancing.

Pros

• Access to funds: The biggest benefit is that you can leverage your home equity to access funds that you can then use for a variety of purposes
• Lower interest rates: The interest rates on a cash-out refinance loan are usually lower than the interest rates on credit cards, personal loans, or other forms of borrowing
• Tax deductions: Depending on how you use the money, the interest on a cash-out refinance loan may be tax-deductible

Cons

• Higher mortgage debt: Cash-out refinancing increases the overall amount you owe your mortgage lender, which means you’ll be paying more interest over the life of the loan.
• Higher interest rates and fees: Cash-out refinancing loans typically come with higher interest rates and fees than the average mortgage.
• Longer loan term: Cash-out refinancing can involve extending the repayment term longer than the original mortgage, which can increase the amount of interest you pay over time. ** Risk of foreclosure**: If you’re unable to make your mortgage payments, you may be at risk of foreclosure, which could result in the loss of your home.

Cash-out refinance vs. home equity loan

Cash-out refinancing and home equity loans are both ways to access the equity in your home. But there are some key differences between the two.

Cash-out refinancing involves replacing your existing mortgage with a new one that has a higher balance, and receiving the difference in cash. A home equity loan, on the other hand, is a second mortgage that allows you to borrow against the equity in your home while keeping your existing mortgage in place.

That means the payment structure is different for each type of loan. With a cash-out refinance, you'll be making a single monthly payment on the new, larger mortgage balance. With a home equity loan, you'll be making a separate payment on that loan, in addition to your regular mortgage payment.

Alternatives to a cash-out refinance

If you're looking to access the equity in your home, but are not interested in a cash-out refinance, there are some alternatives you can consider:

Home equity line of credit (HELOC): A HELOC is a line of credit that is secured by your home and allows you to borrow against the equity in your home. Unlike a home equity loan, which provides a lump sum of cash, a HELOC works more like a credit card, where you can borrow as much or as little as you need, up to a certain limit. HELOCs usually have variable interest rates.

Second mortgage: A second mortgage—or home equity loan—is a separate mortgage that you take out on your home, in addition to your primary mortgage. It provides a lump sum of cash that you can use for a variety of purposes. Second mortgages typically have higher interest rates than primary mortgages, and may come with fees and other charges.

Personal loan: A personal loan is an installment loan that you can use for a variety of purposes, including home improvements or debt consolidation. However, they are not backed by your home. In fact, some personal loans are unsecured, meaning they don’t require any collateral: such as credit card debt. Personal loans typically have higher interest rates than home equity loans or HELOCs, but may be a good option if you don't want to use your home as collateral.

Cash-out refinance FAQ

• Is a cash-out refinance right for you?

When deciding whether a cash-out refinance is right for you, it’s important to evaluate several factors, including your current mortgage situation and overall finances. As with any loan, taking one on if you have unstable income could lock you into a cycle of debt. With stable income, the loan can be a convenient option for paying off a major expense, such as a medical bill. If the loan will be used for renovations that improve your home’s value, then they could be worth it, depending on the expected value the renos will bring. Be sure to compare cash-out refinancing with other options at your disposal, such as a home equity loan or line of credit, before making a final decision.

• When is a cash-out refinance a good option?

A cash-out refinance may be a good option if you have a large amount of equity built up in your home and you have stable income. Remember, defaulting on your loan could put you in danger of losing your home, so it’s important to pursue cash-out refinancing only if you’re confident in your ability to repay the loan.

• How much can I get with a cash-out refinance?

When taking out money with a cash-out refinance, you can’t deplete all the equity in your home. Most lenders require you to leave 20% equity. For example, say your home is worth $250,000 and you currently owe $150,000, meaning you have $100,000 in equity. The lender would calculate 80% of your home’s value—$200,000—which is the maximum you could borrow. That loan would go toward paying off your existing $150,000 mortgage, leaving you with $50,000 in cash.

• Do I have to pay taxes on a cash-out refinance?

The cash you receive from a cash-out refinance is not considered taxable income by the IRS. Instead, it’s considered a loan, so you don’t need to report the proceeds as income on your taxes.