Like many life choices, refinancing your home comes with options. Depending on your financial goals, a cash-out refinance might be the best option for you. With this type of refinancing, you can refinance your mortgage and borrow cash at the same time.
What is a cash-out refinance?
A cash-out refinance replaces your existing home loan balance with a new loan that is greater than your existing balance. You withdraw the difference between the two loans in cash and can use it towards whatever you like. Most people use that money towards debt consolidation or home improvements.
With a cash-out refinance, you could take out a portion of this equity. For example, if you wanted to take out $50,000 in cash, your new mortgage principal amount would be the current balance of $200,000 plus $50,000 totaling $250,000. ALLIANCE allows you to take up to 80% of your equity, but this can vary depending on your credit score and mortgage type.
Advantages to cash-out refinancing
Here are some reasons why a cash-out refinance might be the best option for you:
Debt consolidation: The money you receive can help you pay off high-interest credit cards, which could end up saving you thousands of dollars in interest.
Lower interest rates: If you bought your home when mortgage rates were high, chances are you might be able to secure a lower rate with a cash-out refinance.
Higher credit score: Using a cash-out refinance to pay off your credit cards can help increase your credit score. When you pay down your cards, you decrease your revolving utilization. A lower utilization rate helps increase your credit score and deems you less of a risk to creditors.
Tax deductions: If the money from the cash-out refinance is used to buy, build or substantially improve your home, a mortgage interest deduction might be available.
Disadvantages to cash-out refinancing
A cash-out refinance isn't always the best option depending on your circumstances. Here are some reasons you might want to avoid the cash-out option:
Closing Costs: As with any refinance, you will pay closing costs for a cash-out refinance. Closing costs are usually 2% - 5% of the mortgage — that comes out to be $5,000 to $12,500 for a $250,000 loan. Make sure the potential savings are worth it.
New terms: Securing a new mortgage will have different terms compared to your previous loan. Review your new interest rate and fees before agreeing to the new loan terms.
Foreclosure risk: Your home is used as collateral for any type of mortgage, so if you cannot make the payments, you risk losing your home. If you are using the cash-out refinance to pay off credit card debt, you are using a secured debt to pay off an unsecured debt. This is usually frowned upon since you could possibly lose your home in the process if you do not hold up your end of the loan agreement.
Bad habits: You know yourself better than anyone else. If you plan on using the cash to pay off your credit cards and know that you have trouble controlling your credit card spending, a cash-out refinance might not be the best option for you. You run the risk of succumbing to temptation and maxing out your cards again.
Substitutes to a cash-out refinance
You always want to shop your options with any financial decision you make. Here are some alternative options to a cash-out refinance:
HELOC: A home equity line of credit allows you to borrow money with a revolving line of credit, just like a credit card. Keep in mind that a HELOC has variable rate and changes with the prime rate.
Home equity loan: A home equity loan is a second mortgage. You will receive a lump sum amount that has a fixed rate, which makes planning your monthly payments easy.
Reverse mortgage: A reverse mortgage is for homeowners that are 62 and older. They can borrow against the value of their home and receive either a lump sum, fixed monthly payment, or a line of credit. A reverse mortgage does not require the homeowner to make any loan payments. The entire loan balance becomes due and payable when they move away permanently, sell their home, or die.
The bottom line
A cash-out refinance can be a good idea as long as you plan to use the money wisely. Using the extra cash for a vacation or to buy a new car might not be your best option — you will have little to no return on your money. Tapping into your home equity isn't a decision to take lightly, but doing so with careful consideration can lead to a brighter financial future.