How cash-out refinancing works

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Remember the Mother Goose rhyme about the old woman who lived in a shoe? That is
so 18th century. Today she would live in a piggy bank, and so would her neighbors.

Homeowners today treat their houses like piggy banks, readily transforming their equity into cash and credit. You have home equity loans (still sometimes called
second mortgages), home equity lines of credit and reverse mortgages. Then there’s cash-out refinancing.

Cash-out refinancing explained
With cash-out refinancing, you refinance your mortgage for more than you currently owe, then pocket the difference.

Here’s an example: Let’s say you still owe $80,000 on a $150,000 house, and you want a lower interest rate. You also want $20,000 cash, maybe to spend on your kid’s first semester at Princeton. You can refinance the mortgage for $100,000. That way, you get a better rate on the $80,000 that you owe on the house, and you get a check for $20,000 to spend as you wish.

Cash-out refinancing differs from a home equity loan in a couple of ways. First, a home equity loan is a separate loan on top of your first mortgage; a cash-out refi is a replacement of your first mortgage. Second, the interest rate on a cash-out refinancing is usually, but not always, lower than the interest rate on a home equity loan.

Another difference: You have to pay closing costs when you refinance your loan; you don’t have to pay closing costs for a home equity loan. Closing costs can amount to hundreds or thousands of dollars.

Finally, it doesn’t make sense to refinance a higher amount at a higher rate. If your current mortgage is at a lower interest rate than you could get now by refinancing, it’s probably better to get a home equity loan.

Is cash-out refinancing right for me?
So, if you want to extract a chunk o’ change from your three-bedroom piggy bank, how do you decide whether a cash-out refi is right for you?

It depends on how much you would save each month and what you want to spend the money on.

Let’s take the example of the mythical Jack and Jill Bankrate. They took out a $100,000 mortgage on a $130,000 house in early 1990. Their interest rate was 9.95 percent, making their monthly payment $873.88 (plus taxes, insurance and other extras).

For 11 years, Jack and Jill have been so busy fetching pails of water that they never bothered refinancing. Now it’s the summer of 2001, and they qualify for a rate of 6.75 percent. They still owe $88,400 on their mortgage and they want to grab $20,000 cash to pay for Jack’s cranial surgery. They could refinance $108,400 at a cost of $703.08 a month for 30 years, allowing them to pocket the $20,000. Over 30 years they would pay $253,108.80.

Or they could refinance the $88,400 at a cost of $573.36 a month, then take out a $20,000 home equity loan at 9 percent for 20 years. That would cost $179.95 a month. Added together, they would pay $753.31 a month for 20 years, then $573.36 a month for the last 10 years. Total cost over 30 years: $249,597.60.

With the latter option, they might struggle with higher payments for 20 years, just to save less than $4,000 over 30 years. Which option they take is a matter of personal preference.

When you decide whether to do the cash-out refinancing option, keep in mind that you’ll have to pay private mortgage insurance if you end up borrowing more than 80 percent of your home’s value. If you would have to pay PMI, it might be cheaper to take out a home equity loan.

Spend wisely, dear friends
Even before you do the math, it’s best to take a close look at how you plan to spend the money from cash-out refinancing. Specifically, is the cash for a short-term purpose or a long-term purpose?

If you’re going to make payments for 15 or 30 years, it makes sense to spend the money on something enduring: an addition to the house that will increase its value, potentially lifesaving experimental medical treatment that your health insurance won’t pay for, or to start a business.

If you want to spend the money on a vacation, your daughter’s wedding, a car or a boat, think long and hard. Do you want to make payments on the object of your desire for the length of the mortgage?

In other words, do you want to spend 15 years paying for your monthlong dream vacation? Do you want to spend 30 years paying for that Porsche? The car might be on the junk heap by the time it’s paid for.

Maybe you want the cash so you can bulldoze a mountain of high-interest credit card debt. Yes, you’re paying a lower interest rate and you can take a tax deduction, but you’re probably lengthening the time it would take to pay off the credit card debt.

In essence, you’re taking 30 years to pay off credit card debt that you might have been able to tackle in five or 10 years by cutting other expenses or taking out a shorter-term home equity loan.

Don’t break the piggy bank — you’re living in it.