Pros and cons of cash-out refinance

  • Cash-out refinance can lower borrowing costs, improve cash flow.
  • Tax benefits of cash-out refinance make it attractive way to borrow.
  • Fees and various risks are among drawbacks of borrowing option.

The go-go era of using a house as an ATM is over. But if you are a homeowner with some equity, a cash-out refinance could be a good option to pay for a home project or get rid of high-interest debt.

A cash-out refinance -- where the borrower takes out a new mortgage with a larger principal than the old mortgage and gets cash on the balance -- was a ubiquitous practice before the housing crash that left many homeowners with underwater mortgages. But when used responsibly in a low mortgage-rate environment, a cash-out refinance provides benefits that other types of loans do not.

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When deciding whether or not to pull money out of your home, it's critical to distinguish between "wants" and "needs," says Mary Ellen McCarthy, a registered investment adviser with Responsible Investing of Brookline, Mass.

"Otherwise, we end up treating our home like a cash machine," says McCarthy. "And we've all seen the danger of that."

Pros of cash-out refinance

There are several benefits of a cash-out refinance, including:
  • Improved cash flow and reserves. Using a cash-out refinance to pay off high-interest revolving debts can put you in a better cash flow position. Although you will still carry the debt, you will only have to make one payment each month -- instead of several -- at a much lower interest rate.

    Using the cash-out to squirrel away emergency funds is also becoming a popular option, says Michael Moskowitz, president of Equity Now, a New York-based mortgage lender.

    "People are using cash-out to put the money in the bank just in case they lose their jobs," he says.
  • Better interest rates, improved credit score. Interest rates are typically lower in a cash-out refinance than on a home equity loan and other loans such as home improvement loans or business startup loans.

    "You'll also improve credit scores by paying off or (paying) down maxed out credit cards," says David Kuiper, a certified mortgage planning specialist with First Place Bank of Holland, Mich.

    While cash-out refinancing can buy you breathing room from under 18 percent interest rates or provide funds to fix a leaky roof, it shouldn't be used for play money, McCarthy says.
  • Tax benefits. There are significant tax benefits when you roll your high-interest debt into a mortgage payment: All of the mortgage interest is tax-deductible.

Cons of cash-out refinance

Despite these advantages, there are also some downsides to a cash-out refinance. They include:
  • Fees. Expect to pay hundreds or even thousands of dollars in closing costs. These costs may be minimal if you have a high credit score and high equity on the house.

    In contrast, borrowers with bad credit and low equity may get slapped with extra closing fees. If you borrow more than 80 percent of the value of the home, you may be required to take out costly mortgage insurance.
  • Longer time to pay off a mortgage. You may not want to use cash out financing if you're close to paying off your mortgage -- refinancing will set the payment clock back another 15 or 30 years depending on the mortgage terms.
  • Risk of going underwater. Avoid the trap of becoming a serial refinancer. You could end up in an underwater mortgage if you take out too much equity and real estate values drop further.

People may be tempted to refinance multiple times over the years to pay for expenses such as home improvements or repairs. But McCarthy urges caution.

"Think you're justified putting in a $50,000 kitchen because you think it will increase the home value by $100,000? Well, that's a speculative investment and is an argument people often use to justify to buy what they want as opposed to what they need," says McCarthy.

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