What is a cash-out refinance?
A cash-out refinance replaces your existing mortgage with a new home loan for more than you owe on your house. The difference goes to you in cash and you can spend it on home improvements, debt consolidation or other financial needs. You must have equity built up in your house to use a cash-out refinance.
Traditional refinancing, in contrast, replaces your existing mortgage with a new one for the same balance. Here’s how a cash-out refinance works:
- Pays you the difference between the mortgage balance and the home’s value.
- Has slightly higher interest rates due to a higher loan amount.
- Limits cash-out amounts to 80% to 90% of your home’s equity.
In other words, you can’t pull out 100% of your home’s equity. If your home is valued at $200,000 and your mortgage balance is $100,000, you have $100,000 of equity in your home. You can refinance your $100,000 loan balance for $150,000, and receive $50,000 in cash at closing to pay for renovations.
» MORE: Compare cash-out refi rates
Pros of a cash-out refinance
A cash-out refinance might give you a lower interest rate if you originally bought your home when mortgage rates were much higher. For example, if you bought in 2000, the average mortgage rate was about 9%. Today, it’s considerably lower. But if you only want to lock in a lower interest rate on your mortgage and don’t need the cash, regular refinancing makes more sense.
Debt consolidation: Using the money from a cash-out refinance to pay off high-interest credit cards could save you thousands of dollars in interest.
Higher credit score: Paying off your credit cards in full with a cash-out refinance can build your credit score by reducing your credit utilization ratio, the amount of available credit you’re using.
Tax deductions: The mortgage interest deduction may be available on a cash-out refinance if the money is used to buy, build or substantially improve your home.
Cons of a cash-out refi
Foreclosure risk: Because your home is the collateral for any kind of mortgage, you risk losing it if you can’t make the payments. If you’re doing a cash-out refinance to pay off credit card debt, you’re paying off unsecured debt with secured debt, a move that’s generally frowned upon because of the possibility of losing your home.
New terms: Your new mortgage will have different terms from your original loan. Double-check your interest rate and fees before you agree to the new terms.
If you’re doing a cash-out refinance to pay off credit card debt, avoid running up your cards again.
Closing costs: You’ll pay closing costs for a cash-out refinance, as you would with any refinance. Closing costs are typically 2% to 5% of the mortgage — that’s $4,000 to $10,000 for a $200,000 loan. Make sure your potential savings are worth the cost.
Private mortgage insurance: If you borrow more than 80% of your home’s value, you’ll have to pay for private mortgage insurance. For example, if your home is valued at $200,000 and you refinance for more than $160,000, you’ll probably have to pay PMI. Private mortgage insurance typically costs from 0.55% to 2.25% of your loan amount each year. PMI of 1% on a $180,000 mortgage would cost $1,800 per year.
Enabling bad habits: Using a cash-out refi to pay off your credit cards can backfire if you succumb to temptation and run up your credit card balances again.
The bottom line
A cash-out refinance can make sense if you can get a good interest rate on the new loan and have a sound use for the money. But seeking a refinance to fund vacations or a new car isn’t a good idea, because you’ll have little to no return on your money. On the other hand, using the money to fund a home renovation can rebuild the equity you’re taking out; using it to consolidate debt can put you on a sounder financial footing.
You’re using your home as collateral for a cash-out refinance, so it’s important to make payments on your new loan on time and in full.
Holden Lewis is a writer at NerdWallet. Email: [email protected].