Mortgage rates continue to hover at record lows, and if you own your home, you may be considering whether it’s a good time to refinance. Lowering your monthly payment is a popular reason to refinance your mortgage, but another option is to use a refinance to get cash out of your home, which could be especially attractive right now if you’ve lost income or work hours during the pandemic.
A “cash out” refinance can put money in your pocket when you need it the most, but it also comes with additional cost and risk. Is it worth it? Let’s dig into the pros and cons of a cash out refinance to help you determine if it’s the best option, and how to get started on a cash out refinance if it’s right for you.
How does a cash out refinance work?
With any home mortgage refinance, you’re essentially replacing the entire current mortgage on your house or apartment with a brand-new mortgage, ideally one that has a lower interest rate. In simple terms, if the balance on your current mortgage is $200,000, a refinance replaces it with a completely new $200,000 mortgage.
But in a cash out refinance, you’re increasing the balance of your new mortgage and taking the extra money in cash. So if your current mortgage has $200,000 left on it, but you get a new mortgage for $250,000, that extra $50,000 is yours to keep (minus any closing costs or other expenses related to the refinance).
Not just anyone can get a cash out refinance. As with any new mortgage, you need to be able to show you have enough income to cover the monthly payments, as well as a decent credit score. The lower your credit score, the harder it is to qualify for a refinance and the more you’ll pay in interest with higher rates.
You also can’t take every last penny out of your home in a cash out refinance. “Most lenders require at least 20% equity right now to approve a cash out loan,” says Julian Hebron, founder of The Basis Point, a consultancy to banks and fintech companies. Equity is the amount of your home that you own yourself, as opposed to the part you owe your lender. “This means the new loan balance that includes the cash out must not exceed 80% of your home’s value,” explains Hebron.
You can calculate your current equity by determining how much your home is worth, then subtracting the debt you owe on it. So in our example, if you currently owe $200,000 on your mortgage and your home is worth $350,000, your equity is roughly 43% (because 350,000 minus 200,000 is 150,000, which is about 43% of 350,000).
If you do a cash out refinance and the new mortgage is $250,000, you’ll have only 28.5% in equity when you’re done — the home is still worth $350,000, but you now have $250,000 in debt on it, and the remaining equity is now just $100,000, which is about 28.5% of the home’s $350,000 value.
Once you know what your home is worth, you can calculate how much you can get in a cash out refinance while still keeping 20% in equity. “If you want to do the math yourself, add your desired cash out to your existing loan balance, then divide that number by 80% (or .80 on your calculator) to get the value you must have,” advises Hebron.
Also, since you’re increasing your mortgage balance and decreasing your equity with a cash out refinance, the risk to the lender is higher. Therefore, you’ll likely pay somewhat higher costs and potentially higher interest rates. According to Hebron, interest rates for cash out refinances are 0.125% to 0.25% higher than rates for a standard refinance or mortgage on a newly purchased home.
Lower rates can mean lower overall payments, even when taking cash out
Although in many cases you’ll end up with a higher monthly mortgage payment after a cash out refinance, you might actually pay less per month overall across all your debt if you use the money wisely.
Again, using our example, let’s say you bought your house five years ago and got a standard 30-year mortgage for $220,000 at a 4.5% interest rate. You now have 25 years left on that mortgage and a balance of about $200,000, and your monthly payment is roughly $1,115 a month (not including taxes, insurance and any other escrow expenses).
If you do a cash out refinance for $250,000 on a new 30-year mortgage and are able to drop that interest rate from 4.5% down to 3%, your payment will go down to about $1,054 a month (again, before taxes, insurance and other monthly costs). That’s $60 less each month, and you’ll walk away with a substantial amount of cash that you can use right now.
In other cases, you can take cash out of your home and still keep roughly the same payment you have now. “Let’s say you got a $200,000 30-year fixed loan at 4% when you bought your home in spring 2019,” explains Hebron. “As long as you have enough equity in the home, today you could take out up to $25,000 with a cash out refinance at around 3.25% and keep your payment the same.”
But depending on what you do with that cash, you could save even more each month. For instance, if you’re currently sitting on $20,000 in credit card debt and you use some of the cash from your refinance to pay off those credit card balances, you’re getting rid of that monthly cost as well. And credit card interest can be sky-high — as much as 20% or more.
So if you have $20,000 in credit card balances at a 20% annual interest rate, that equals over $300 a month in interest costs. Even if your new mortgage payment is higher than your old one, your total monthly payments across all your debt may potentially drop if you use the cash to pay off those high-interest credit cards.
Some people don’t think you should use a home loan to pay off credit card debt, because you’re essentially converting it from an unsecured debt to one that’s secured by your home (not to mention stretching out the payments over decades). But in this economic downturn, many people are looking to cut their monthly costs first and foremost, and consolidating debt by using a cash out refinance can be a good way to go about it.
But extending your mortgage means paying more interest overall
Unfortunately, nothing in life is free, and even the benefits of a cash out refinance come with a cost.
First, even if your monthly mortgage payment drops after a refinance, it’s likely you’ll end up paying more interest in total over the life of your mortgage. That’s because a refinance essentially restarts your mortgage from the beginning.
In our example from earlier, if you’ve already paid five years of your original 30-year mortgage but then refinance into a new 30-year mortgage, you’ll end up paying interest for 35 years in total when all is said and done — five years on the first mortgage, and 30 years on the refinanced mortgage (assuming you own the house until the mortgage is entirely paid off). That can easily add up to tens of thousands of extra dollars in total interest than if you had just stuck with the original mortgage.
What’s more, all mortgages are front-loaded, meaning you pay more interest than principal at the beginning, then more principal and less interest as the mortgage matures. But refinancing means you start the process over, resetting with a new mortgage with the interest front-loaded again.
One way around this is to choose a shorter term for your refinance. For instance, if you’re already 10 years into a 30-year mortgage, you could choose to refinance into a 20-year mortgage instead of a new 30-year one. Not only will you save years of extra interest with this method, but you’re likely to get a lower interest rate on top of it, since shorter mortgages generally come with lower rates. You’ll also move faster through the front-loaded portion of a shorter mortgage and start paying down principal quicker.
However, if you’re also taking cash out during your refinance and increasing your overall mortgage balance as a result, you can expect to end up with a higher monthly payment on a shorter term mortgage. While the numbers vary depending on your situation, if you keep your total mortgage length the same in a refinance but increase the balance, you’ll likely have to pay more each month to get it all paid off in time, even with a lower interest rate.
Don’t forget to factor in closing costs, taxes and lost equity
Refinancing your mortgage isn’t a free process. Lenders charge money to execute a refinance, including an origination fee, appraisals, inspections and other expenses. “Refinance closing costs can range from $2,000 to $5,000 depending on where you live and the price of your home,” says Hebron.
Some of these costs may be negotiable, or you can request a refinance with no closing costs, which reduces your upfront expenses but comes with a higher interest rate.
Also, if you’re refinancing your primary residence and use the extra money from a cash out refinance on non-home expenses (such as consolidating credit card debt), that portion of your interest is not tax deductible. You’ll need to consult with a tax professional to determine how a cash out refinance will affect your tax liability.
Even if you use the extra cash for home improvements or other related costs, in some cases, you might actually find that your overall mortgage deduction ends up lower after a refinance. That’s because even if you increase your mortgage balance with a cash out refinance, a lower interest rate may mean lower monthly interest payments and a smaller tax write-off.
Also, keep in mind that when you take cash out of your home, those funds are essentially coming from your own pocket. Because if you don’t take the cash now, you’ll get it when you sell your house or apartment. Even if the value of your home goes up or down in the intervening years, the money you get in a cash out refinance effectively reduces the equity you end up with at the end of your home ownership.
Is a cash out refinance right for you?
When deciding whether a cash out refinance makes sense for you, think of it as borrowing money from your future self — the extra money you get now is money you won’t get when you sell your home. Whether that’s a good choice or not depends on your current circumstances.
If you or your family have taken a hit financially and you need cash now, then a cash out refinance can make sense, as the overall costs of a refinance may be worth the trade-off. However, if you’re planning to use the cash from a refinance to cover everyday costs, you’ll want to reduce your household expenses as much as possible before relying on the one-time infusion from a refinance.
But avoid thinking of a cash out refinance as a magic cure-all. If you start treating your house or apartment like a piggy bank, eventually you’ll run out of equity and could even lose your home if you can’t afford your monthly payments.
How do you get started on a cash out refinance?
There are several ways to get the ball rolling on a cash out refinance. You can contact your current lender, other lenders or a mortgage broker. But one of the easiest ways can be to use an online lending marketplace.
An online marketplace like LendingTree lets you compare cash out refinance options without having to reach out to individual banks, credit unions and other lenders one at a time. Best of all, you only have to submit your information and requirements once, and there’s no cost to seeing the offers, so you can get an idea of your options without having to pay anything.
So if you’re tight on cash right now, take a look at all of the possibilities for extra funds, your ability to repay money in the future and your personal situation. Then, consider reaching out to lenders to explore whether a cash out refinance makes sense for you.