Is a Cash Out Refinance a Good Idea? Weigh the Pros and Cons

See if You Can Save Money by Using Your Home Equity to Finance Your Goals

With home values rising in communities across America, many homeowners have the opportunity to borrow cash using the equity in their home with a cash out refinance.

A cash out refinance lets you borrow money from the value of your home’s equity by replacing your original mortgage with a new mortgage for a higher amount and collecting the difference in cash at closing. For example, if you have a $150,000 mortgage, you might be able to get a new mortgage for $200,000 and receive $50,000 in cash back by refinancing.

Is a cash out refinance a good idea for you? Read on to learn more about the advantages and disadvantages of cash out refinancing.

At a Glance: Cash Out Refinance Pros and Cons

It's important to understand how a cash out refinance works before you move forward with taking out this type of loan. The table below shows some of the pros and cons so you can make an informed choice.

Benefits of a Cash Out Refinance

Cash out refinances allow you to borrow money from your home equity to pay for home upgrades, college educations, and other important expenses. Because the loan is secured by your home, the rates on cash out refinances are almost always much lower than the rates on credit cards, personal loans, and other types of unsecured debt.

The money you'll get from a cash out refinance can help you pay for important goals. Potential pros of a cash out refinance include:

• Access to a large amount of money: Lenders may allow your cash out refinance total loan-to-value ratio to be as high as 80% to 90% of the market value of your home. If you have a substantial amount of equity, you can borrow a lot of money through a cash out refinance.
• Lower interest rates: Cash out refinances also have lower rates than home equity loans and home equity lines of credit (HELOCs). That's because cash out refinances are considered "first mortgages," and home equity loans and HELOCs are considered "second mortgages." Since lenders are required to consider second mortgages as having more risk than first mortgages, they typically charge a higher interest rate as a result.
• Home improvements: You can use cash out refinances to make your home more comfortable and increase its value through home renovations. Note that most home renovations do not give you a dollar-for-dollar return on what you spend. However, using home equity for home improvements qualifies for an interest tax deduction.
• College education: Paying for college and other kinds of education can help you or your family earn more money or advance your careers. Learn more about ways to pay for college.
• Debt consolidation: When you have higher-interest debts, a cash out refinance can help you consolidate your debt into a lower interest rate, which could mean a single monthly payment and paying less each month in interest.
• Business investments: Homeowners can use their equity to help fund a new business venture or other kinds of investments.
• Tax benefits: You may be able to deduct interest when you use the money from a cash out refinance to pay for home upgrades. Learn more about the tax implications of cash out refinances.
• Improved loan terms: A cash out refinance gives you the opportunity to change the rate and other terms of your mortgage. For example, if you have 20 years left on your mortgage, you might choose to increase your term to 30 years or decrease it to 15 years when you refinance.

Here are some factors to consider:

There are also some downsides of a cash out refinance that you need to think about before you move forward with borrowing. Here are some of the biggest disadvantages:

• Increased debt: When you borrow against equity from your home, this increases your debt. More debt means higher payments, more interest costs, and a reduction in your net worth.
• Closing costs: There are closing costs to pay on all mortgage loans. These costs can typically add up to 2% to 5% of the loan amount.
• Risk of foreclosure: If for some reason in the future you can't afford the payments on your cash out refinance loan, you risk foreclosure.
• Depleted equity: When you take equity out of your home, you owe a larger percentage of the home's value. This increases any slight risk that you could end up owing more than the market value of your home, which could make refinancing or selling difficult in the future.
• Longer loan term: Generally, you reset the clock on repaying your loan when you take out a cash out refinance loan. If you had 25 years left on your loan and refinance to a new 30-year mortgage, this means you now have five extra years of payments to make.
• Higher monthly payments: Since you are borrowing more money, your monthly mortgage payment will increase.
• Potentially higher interest rate: If you cannot qualify for a new cash out refinance loan at a lower rate than your current mortgage, you will increase the financing costs of your home loan balance.

Should You Get a Cash Out Refinance?

A cash out refinance loan can make good sense in certain situations because the upsides greatly outweigh the downsides. However, you need to carefully consider whether this type of loan makes sense for your specific situation.

Let's take a look at situations when a cash out refinance loan would make sense, and situations when you should wait.

When a Cash Out Refinance Might Be a Good Idea

There are many good reasons to get a cash out refinance. You may want to take out this type of loan if:

• You can reduce the interest rate on your current mortgage
• You have a lot of equity in your home you can use for important goals such as consolidating debt, paying for college, or improving the value of your home
• You need to change your loan terms. For example, a cash out refinance could allow you to change from a fixed-rate loan to an adjustable-rate loan

Think about what you hope to accomplish with getting a new loan, and how the decision will affect both your monthly budget and your finances over the long term.

When You Should Wait To Get a Cash Out Refinance

There are also times when it makes sense to wait to get a cash out refinance. You should wait to take out this type of loan if:

• You can't qualify for a new loan at a lower interest rate, don't want to make your current mortgage more expensive and you want to borrow much less than the principal you still owe.
• You don't have enough equity in your home
• You aren't sure you can comfortably afford the new monthly payments from your cash out refinance loan
• You don't have an immediate need to tap the equity of your home for an important goal

Generally, it's not a good idea to get a cash out refinance to pay for things like vacations or discretionary purchases. Tapping your equity makes good sense, but only for a good reason.

Cash Out Refinance Alternatives

A cash out refinance isn't the only option if you want to tap equity in your home, change the terms of your current loan, or access money to refinance debt or fund other big goals. Here are some alternatives to consider if a cash out refi loan isn't the right choice for you.

• HELOC: A home equity line of credit or HELOC is a revolving loan that is guaranteed by your home's equity. You're allowed to borrow up to a set limit and make payments only based on what you borrowed. You can draw from your line of credit as needed, giving you ample flexibility.
• Home equity loan: A home equity loan is a loan for a flat amount that is secured by your home's equity. You receive a lump sum up front and pay back the loan over time. Your current mortgage is not affected by the new home equity loan.
• Mortgage recast: A mortgage recast allows you to reduce your current mortgage payment by making a large one-time lump sum payment. When your payment reduces your balance, your lender recalculates your remaining payments to account for the fact you paid down some of the principal.
• Personal loan: Personal loans are available from banks, credit unions and online lenders. They are typically unsecured loans, which means you don't use your house or any other collateral to guarantee the loan. The interest rate may be much higher than on a cash out refinance loan because the debt is unsecured.
• Reverse mortgage: Reverse mortgages are available to seniors who own their own homes. You can access equity without making payments until you pass away or sell your home. However, reverse mortgages can sometimes be complicated and come with high fees and interest.

Final Thoughts: Cash Out Refinances Come With Pros and Cons

A cash out refinance is one of the least expensive ways to borrow money to consolidate debt or pay for home upgrades or educational costs. If you're a homeowner with significant home equity, you may be able to save a lot of money when you tap into that equity to get the cash you need. Contact a Freedom Mortgage loan professional to get prequalified or to find a loan that's right for you.