Pros and cons of a cash-out refinance

A cash-out refinance allows you to convert a portion of your home’s equity into cash. Some homeowners use the funds to consolidate debt and fund home improvement projects or higher education costs. Others start businesses, invest in rental properties or make other big-ticket purchases.

This mortgage refinancing option is a popular choice among homeowners as it offers attractive interest rates compared to those you’d get on a credit card. Also, depending on how much home equity you have, you could get more money through a cash-out refi than with a personal loan or on a credit card. However, be sure to weigh the pros and cons before committing to a cash-out refinance.

What is a cash-out refinance?

In a cash-out refinance, you retire your existing mortgage and withdraw a portion of your home’s equity in a lump sum. You also get a new and larger mortgage that accounts for the difference between the amount you owe on your home and the funds you access in cash.

Most lenders allow you to access up to 80 percent of your home’s value. This amount could vary, though, depending on your creditworthiness, property type and your existing mortgage. Lenders generally require you to maintain at least 20 percent equity in your home (though there are exceptions) after a cash-out refinance, so if you bought a home recently with a low-down payment loan, you might not qualify.

Cash-out refinance pros and cons

As with any financial decision, a cash-out refi comes with advantages and disadvantages. Keep them in mind as you explore your options to determine if this mortgage refinancing method is best for you.

Pros

• Access to large loans: The biggest upside of a cash-out refinance is that you get the money you need to upgrade your home or pay down debt by unlocking the equity you already have.
• Predictable payments: Most borrowers who take cash-out refinances do so with 30-year fixed-rate mortgages. That means you know how much your monthly payments will be. That’s not the case with other options for tapping home equity — many home equity lines of credit, for example, carry variable, rather than fixed, rates.
• Upgrades can boost your home’s value: Depending on the type of renovation you fund with your cash-out refi, the improvements could increase your property value and further build your equity. Kitchen and bath remodels are especially effective on this front.
• Potential tax deductions: Renovations can also make a difference when you file your taxes. In general, you can deduct the interest you pay on the mortgage so long as you use the funds to make improvements that add value to the home. Improvements can also increase your tax basis in the house, which will reduce your capital gains tax liability when you sell.
• Lower interest rates: Compared to credit cards, personal loans and other types of debt, mortgages offer a combination of low interest rates and favorable terms. Additionally, as you pay down your mortgage over time, you’re building equity in a valuable asset.
• Potential to boost your credit score: If you use a cash-out refi to consolidate high-interest credit card debt, your credit utilization will decrease. Consequently, your credit score may improve.

Cons

• You owe more: With a cash-out refinance, your overall debt load will increase. No matter how close you were to paying off your original mortgage, the extra cash you obtained from the refinance is now a bigger financial burden.
• Closing costs: Just as you had to pay closing costs on your original mortgage, you’re going to need to pay similar expenses when you refinance. Those can be significant — the credit check, appraisal and other costs can add up to 2 to 4 percent of the loan amount.
• Foreclosure risk: Your home is used as collateral to secure the mortgage. Failure to make timely payments on the new loan could result in foreclosure.
• You might be kicking your debt can down the road: Financial experts say tapping home equity to pay for renovations is a wise move. But if you’re cashing out to pay off high-interest debt on credit cards, take a long pause. Make sure you’ve addressed whatever spending issues led you to run up the debt in the first place. Otherwise, you might find yourself in a debt spiral.

Should I get a cash-out refinance?

A cash-out refinance could be ideal if you qualify for better terms than you currently have and plan to use the funds to improve your finances. This could include upgrading your home to boost its value or consolidating high-interest debt to free up room in your budget.

But if your credit score is on the lower end and you won’t qualify for favorable rates, a cash-out refinance may not be a smart financial move. In fact, it could be too costly and leave you with a monthly mortgage payment that stretches your budget too thin.

In addition, if you expect to sell your home in the near future, it might not make sense to refinance for a cash-out loan; you’ll have to repay the larger balance at closing.

It’s also best to steer clear of a cash-out refinance if you don’t have a specific need for the funds or if it’ll come with steep closing costs. Also, avoid this mortgage refinancing option if you want to pay off your home soon.

Bottom line

A cash-out refinance can be a smart way to pay for home improvements and renovations or pay down high-interest debt. That said, you need to have adequate equity in your home, and ideally, get the lowest possible rate. Otherwise, an alternative option, like a home equity loan, could be a better choice.