Cash out refinancing is where you extract the equity from your home, liquidating it as cash through a second loan.
Sometimes people use this cash to pay off their mortgage, but more often “cash out” refinancing refers to extracting this cash for other purposes like medical bills, vacations, home improvements, tuition, and so on.
Are you thinking about cash out refinancing? If so, you should look at the pros and cons before you commit to the prospect.
Benefits of cash out refinancing include:
- This one is obvious, as it’s the reason you’re thinking of doing it. Cash flow can help you to pay off other debts (especially high interest loans), and can give you money for emergencies or for higher paying investments. If you are struggling with your mortgage, you can sometimes refinance at a lower interest rate and pay off your first mortgage.
- Improving your credit score. If you use some of the cash from your cash out refinance to pay off other debts, you can boost your credit score. This can obviously provide you with valuable options in the future.
- Tax deductions. Your mortgage interest is tax deductible, so you can save money on taxes by consolidating your other debts and eliminating their separate interest rates.
Drawbacks of cash out refinancing include:
- Higher closing costs. You will have to pay much more money in closing costs if you refinance—unless your credit score is very high and your amount of equity was also quite high. If your credit is bad though or if you only owned a small percentage of the home (or borrowed a much larger percentage than you did own), you will probably have to pay hundreds or thousands of dollars in closing fees. You may also have to obtain mortgage insurance, which can be a hefty monthly bill.
- Longer mortgage duration. Refinancing can add time—a lot of time—to your mortgage. You may end up with another 15 or 30 years of payments to make, which would be quite counterproductive if you are already close to paying off your entire mortgage.
- Ending up underwater. Lots of people who have refinanced a home have discovered that they are in a losing investment. In particular, people who refinance to make improvements to their homes with the object of “increasing the home’s value” often find that the home’s value hasn’t increased at all—but what they are paying for it certainly has.
Cash out refinancing is largely a question of wants vs. needs. Do you want the money for something or do you need the money for something? How critical and immediate is that need? Does it justify all the drawbacks?
A surprising number of homeowners talk themselves into thinking that they do need things which they clearly don’t, including expensive vacations! This is obviously a poor use of the money you’ve invested in your home.
The option does exist though, and if you’re thinking of doing it to get a lower interest rate on a mortgage or simply to have some money for emergencies, it’s probably not a bad idea. Don’t forget that you don’t have to take out more than you’ve put in either, especially if you aren’t doing it to pay off your mortgage.