Pros and Cons of a Cash-Out Refinance

Pros of a Cash-Out Refinance

A cash-out refinance loan can be a great option if you need access to a large sum of money, and there are several benefits associated with the process.

Access to a Large Sum of Money

If you have a significant amount of equity in your home, a cash-out refinance allows you to access a good chunk of it. Lenders typically allow you to borrow up to 80% of your home's value, though some may be willing to go up to a loan-to-value ratio (LTV) of 90%.

Depending on your current LTV, that could translate to tens of thousands of dollars in cash, which you can use for just about anything you want.

Lower Interest Rates

In some cases, you may be able to secure a lower interest rate with your cash-out refinance loan. This is especially true if market rates have declined since you first took out the loan or your credit score has improved significantly since then.

Potential Tax Benefits

The IRS doesn't view the cash you receive from a cash-out refinance loan as income, so it's not taxable. Additionally, if you use the funds to buy, build or substantially improve your home, you can deduct the interest you pay on that portion of the new loan on your tax return.

Just keep in mind that you can't do this for funds used for other purposes.

Learn more: What Is the Mortgage Interest Deduction?

Opportunity for Debt Consolidation

A popular way to use a cash-out refinance loan is to consolidate high-interest debt. This can be particularly helpful if you have credit card balances, where you'd be trading debt with an average rate upwards of 20% for a single-digit interest rate.

Depending on how much debt you have, a cash-out refinance could help you save thousands of dollars on interest charges. It may also help improve your credit by lowering your credit utilization rate on high-balance credit cards.

Learn more: Should I Do a Cash-Out Refinance to Pay Off Debt?

Extended Repayment Term

Like purchase mortgage loans, a cash-out refinance loan will typically have a 15- or 30-year repayment term. In other words, you may be able to use the loan to extend your term and help offset some of the potential increase in your monthly payment.

Cons of a Cash-Out Refinance

Although there are some clear upsides to a cash-out refinance loan, it's also important to understand the potential drawbacks and risks.

Risk of Foreclosure

Even with an extended repayment term, you may end up with a higher monthly payment than you had with your initial home loan. This can increase your risk of falling behind on payments and facing foreclosure.

Closing Costs

Like a standard mortgage loan, a cash-out refinance loan has closing costs, which can range from 2% to 5% of the loan amount. On a $400,000 loan, for instance, you could be on the hook for $8,000 to $20,000 in upfront costs, which could neutralize any potential savings you may enjoy from, say, debt consolidation.

In some cases, you may be able to roll those costs into the loan, but that means a higher monthly payment and more interest charges.

Learn more: Can You Negotiate Closing Costs?

Higher Overall Interest Cost

Taking on more debt will result in higher total interest costs over the life of your loan, even if the cash-out refinance loan amount is lower than your starting mortgage balance when you bought the house.

That's especially true if you extend your repayment term and roll your closing costs into the new loan.

Mounting Debt

If you're using a cash-out refinance loan to consolidate existing debt, your total debt load won't change. However, if you use it to make home improvements, pay for college costs, cover medical bills or anything else, you may be taking on more debt than you can handle.

As a result, it's crucial that you evaluate your financial situation before taking out a loan to ensure that you can manage it comfortably.

Restarting the Loan Term

If you've only lived in your home for a couple of years, restarting your loan term may not make a huge difference. However, if you've been in the home for a long time, a cash-out refinance loan means that you'll be in debt longer.

What Are the Requirements for a Cash-Out Refinance?

The requirements for a cash-out refinance loan can vary somewhat depending on the lender. However, here are some general guidelines to keep in mind as you consider your options:

• Credit score: You'll typically need a credit score of 620 or higher to get approved, but a higher credit score is required for higher LTVs.
• Home equity: You'll need to have more than 20% equity in your home, though some lenders may accept lower amounts. This figure will be based on a new appraisal of your home rather than the initial appraisal performed when you bought the house.
• Debt-to-income ratio: You'll typically need a debt-to-income ratio (DTI) of 43% or less, including the new monthly payment. Higher DTIs may be accepted, but you'll typically need a higher credit score to compensate for the additional risk.
• Income and employment: The lender will need to verify your employment status and income to ensure that you can afford to repay the debt. If you've recently switched jobs or your income is lower than when you took out the initial loan, it may be difficult to get approved.

Should You Get a Cash-Out Refinance?

Before you apply for a cash-out refinance, it's important to assess your financial situation and objectives. However, here are some scenarios where it can generally make sense to get one:

• You have a significant amount of equity in your home.
• You want to consolidate high-interest credit card debt with the new loan.
• You're looking to make some home improvements and want the tax benefits.
• You can qualify for a lower interest rate than what you're currently paying.
• You can comfortably afford the closing costs and the new monthly payment.
• You want to switch from an adjustable-rate mortgage to a fixed-rate mortgage while also accessing equity.

That said, there are some scenarios where a cash-out refinance might not be the best choice. Examples include:

• You don't have enough equity to qualify or make it worth the costs.
• You've been in your home for a long time and don't want to restart your repayment term.
• You can't afford a higher monthly payment.
• You plan to sell the home in the near future.
• You don't qualify for a lower interest rate than what you currently have.
• You're already struggling to manage your debt situation.
• You can't afford closing costs and don't want to roll them into the loan.

Learn more: Reasons Not to Tap Into Home Equity

Alternatives to a Cash-Out Refinance

If you're unable to pursue a cash-out refinance or you're not sure it's the right fit for you, here are some potential alternatives to consider:

• Home equity loan: A home equity loan is another way to tap your home's equity with a lump-sum disbursement. While closing costs are similar, they won't be based on your full mortgage balance, just the amount of equity you're borrowing.
• Home equity line of credit (HELOC): A HELOC works similarly to a credit card, allowing you to tap equity with a revolving line of credit. This option may be worth considering if you want ongoing access to credit.
• Reverse mortgage: If you own your home outright or have an extremely low balance, a reverse mortgage can give you regular payments based on your home's value. That said, these loans are reserved for older homeowners.
• Personal loan: A personal loan doesn't use your home's equity as collateral and can be used for a variety of purposes. It may be beneficial for smaller financial needs.

Frequently Asked Questions

Improve Your Credit to Maximize Your Savings

Whether you decide to pursue a cash-out refinance or one of its alternatives, you can bolster your chances of securing a low interest rate by improving your credit.

Because your score is based on your unique credit history, check your Experian credit report and FICO^® Score^☉ to get a feel for where you stand and where you can get started. This process can take time, but the long-term savings are often worth it.