Pros and Cons of Cash-Out Refinancing
Cash-out refinancing is an easy to understand form of borrowing. With cash-out refinancing, you refinance your current mortgage for more than what you owe and take the difference in cash. Say you owe $120,000 on a home worth $200,000; you could refinance the mortgage for $150,000, paying off the old mortgage with $120,000 while putting the additional $30,000 in your pocket.
Then, of course, you would start making payments on the $150,000 mortgage.
Why would you choose cash-out refinancing?
- To make home improvements
- To make major purchases
- To pay for college, major medical expenses, etc
- To consolidate high interest rate debt (credit cards, auto loans, etc)
- To pay for a vacation or other luxury items
- To help finance the purchase of other properties
- To make other investments
While they may seem similar, cash-out refinancing is different from getting a home equity loan or a home equity line of credit. Both result in cash in your pocket, but:
- A cash-out refinance loan is a new loan; it replaces your old mortgage and becomes your new "first" mortgage.
- A home equity loan or line of credit is a separate loan; it becomes a "second mortgage," separate and distinct from your current or original mortgage.
- Closing costs are required when you refinance a mortgage (although they may be somewhat lower than normal if you refinance your original mortgage using the same lender).
- Home equity loans and lines of credit generally do not require closing costs; if closing costs are required, they are typically much lower than for a first mortgage.
Cash-Out Refinancing: The Pros
- Cash out refinancing generates a lump sum you can use in any way you wish.
- Qualifying for cash-out refinancing is typically easier; you already own the home and have established a payment history, and you owe less than what the home is worth (or else you would not qualify in the first place).
- Using cash generated by cash-out refinancing to pay off other debt that is not tax deductible could result in additional tax savings, since mortgage interest is tax deductible.
- Interest rates for first mortgages are generally lower than for home equity loans or lines of credit.
Cash-Out Refinancing: The Cons
- Closing costs are typically higher than for home equity loans or lines of credit.
- Cash-out refinancing will cause you to "reset" your current mortgage, extending the term over which you must make payments on a mortgage (unless you refinance for a lower number of years, of course).
- Borrowing more than 80% of the value of your home could require you to pay private mortgage insurance (PMI), potentially adding hundreds of dollars to your monthly payment.
- You will probably not qualify for a cash-out refinance until you have lived in the home for at least a year (called "loan seasoning"). Until that time has passed you may not be able to refinance.
Here are a few simple scenarios that might help you decide whether cash-out refinancing is right for you:
- If interest rates are lower than for your current mortgage, a cash-out refinance could put money in your pocket and lower your monthly payments − or at least keep your payment relatively flat.
- If interest rates are higher, a cash-out refinance probably doesn't make sense. Choose a home equity loan or line of credit instead.
- Even if interest rates are lower, consider the age of your current mortgage. If you have been making payments for ten years on a thirty-year mortgage, a significant portion of your monthly payment now goes to paying off principal instead of interest. Refinancing into a lower rate won't have as much impact, and your loan will be "reset," causing you in effect to turn what was a twenty-year mortgage into a thirty-year mortgage.
- If you plan to use the funds over a number of years − like, for example, to pay for college − consider a home equity line of credit. That way you can withdraw money only when you need it, and pay interest only on the amount withdrawn to date. With a cash-out refinance, you'll start paying interest on the entire amount immediately.