Have you ever heard the phrase “using your house like a piggy bank” and wondered how exactly that works? The answer: a cash out refinance. A cash out refinance lets you pocket some of the value of your home. You see some instant return on all those mortgage checks you’ve sent in. Here’s how it works.
If you’re considering a cash out refinance, a financial advisor could help you weigh the pros and cons for your financial plan.
Cash Out Refinancing Basics
Like any refinance, a cash out refinance is a new loan. You replace your existing mortgage with a new (and improved, we hope) refinance mortgage. With regular refinancing (also known as rate and term refinance), you get a new mortgage equal to the amount you still owe on your home. Your new mortgage could be designed to change the length of your mortgage term, or to change the interest rate you pay. But with cash out refinancing, you get a new mortgage for an amount that exceeds what you currently owe. Then, you cash out the difference.
Cash out refinance mortgage amount – Amount left on current mortgage = Amount you cash out
People use cash out refinancing when they need a lump sum of money, say, to pay off high-interest credit card debt. Cash out refinances often come with longer mortgage terms, to keep borrowers from seeing a big jump in their monthly mortgage bill.
Depending on your financial situation, a cash out refinance could be a smart move. Here are four common benefits:
- Opportunity for a lower interest rate. If your mortgage was taken out at a higher interest rate, your cash out refinance might be lower. Though if you’re only looking to reduce your mortgage rate, you could benefit instead by refinancing your existing mortgage to reduce or extend the time frame.
- Access to money without selling your home. The big, obvious advantage to a cash out refinance is that you get money from your home equity without having to sell the home. You can use that money for anything you want, though often people use the funds for home renovations.
- Opportunity to consolidate debt. A cash out refinance can help you pay off credit cards and other debts, with the potential of saving money on interest. The refinance can also help you consolidate multiple debt payments into one.
- Tax benefits. Another advantage to a cash out refinance is that you don’t have to pay taxes on the amount you cash out, and you can still write off interest payments. Nice, right?
A cash out refinance is a fairly risky financial move. Here are six common disadvantages:
- You lose equity. When you commit to a cash out refinance, you forfeit some or all of the equity you’ve worked hard to build. That lowers your net worth, and means you’ll get less out of a future home sale.
- You could end up under water. If you give up home equity to take on a cash out refinance, you run the risk that the value of your home could drop. You could end up owing more than your home is worth. Not good.
- You pay more interest. The more you borrow, the more interest you pay. That means less money in your pocket and more money for the Wall Street Fat Cats. Or whomever. Remember that with a cash out refinance, you pay interest on the money you cash out. It’s not free, even though it’s your equity that you’ve built.
- You might not break even. Refinancing means paying closing costs anew. So if you take a few thousand out in your cash out refinance, but pay a few thousand in fees to close the mortgage, you won’t come out ahead. And you’ll be paying interest on the amount you cashed out. Or, if you refinance and then move right away, you might not be in the home long enough to break even.
- You might end up with a higher interest rate. Cash out refinancing could come with a higher interest rate than than the rate you currently have, depending on your circumstances and your lender. Higher rates mean more interest over the life of the loan.
- You could struggle to pay back the loan. If you sign on the dotted line for a hefty new mortgage as a cash out refinance, you’re taking on more debt. If a job loss or illness cuts into your budget, you could find it hard to keep up with payments.
Cash Out Refinance Rules
The rules of cash out refinance vary from lender to lender, but there are some universal truisms. Lenders generally require that borrowers stick to a “seasoning” period of 12 months before committing to a cash out refinance. In other words, you’ll need to have owned the home for a year before seeking a cash out refinance. Cash out refinances also usually come with a loan-to-value ratio (LTV) rule. You probably won’t be able to get a cash out refinance mortgage with more than an 80% LTV.
When you’re considering a cash out refinance, you don’t have to prove that you can afford the extra debt, or that you’re planning on using the cash for paying off high-interest debt or making investments. The catch is that you still have to keep up on the payments for your new, bigger mortgage. And as we’ve covered, there are some risks involved.
If you don’t need cash but you do want to take advantage of lower interest rates, consider a regular old rate and term refinance. You’ll still have to pay the closing costs, but you won’t be taking on more debt than you already have.
Tips for Homebuying
- A financial advisor can help you create a financial plan for your homebuying goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before taking out a mortgage, make sure you can pay for all the costs. Factor in all fees and calculate the property taxes for your area.
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