How to use a cash-out refinance
When you need cash for a major expense, a cash-out refinance聽lets you use your home鈥檚 value as a piggy bank. Cash-out refinances are聽useful in certain situations, but lending experts caution that tapping into your home鈥檚 equity to pay off short-term debts can be a slippery slope if you don鈥檛 have聽the right discipline.
When you perform a cash-out refinance, you take out a new loan聽for an amount greater than your current mortgage balance. You鈥檒l use part of this loan to pay off your mortgage, and you鈥檒l receive the rest聽in cash at closing. You can use the remaining money for whatever聽you want: home improvements, medical bills, college tuition, credit card bills or large purchases.
Lax lending practices and astronomical home values pushed cash-out refinancing to its peak in 2006, when homeowners cashed out聽$320.5 billion in total home equity volume, according to Freddie Mac鈥檚 Cash-Out Refinance Report. Since the 2007 housing downturn, however, plummeting home values and stricter borrowing requirements resulted in a decline of cash-out refinance loans 鈥� until now.
With property values on the rise in many metro markets and聽聽dipping, cash-out refinancing is making a comeback. An estimated $30.6 billion in home equity was cashed out by the end of the third quarter of 2015, Freddie Mac reported.
Cash-out refinancing may be on the rise, but because it聽can be聽risky, it鈥檚 important to ensure that you鈥檙e doing it for the right reasons.聽Let鈥檚 take a look at some good, and some not-so-good, uses for money from a cash-out refinance.
Spend it on home improvements
Let鈥檚 say you want to finish a basement or upgrade an outdated kitchen or bathroom. The upfront expenses are costly, but the value that you鈥檒l add to your home聽can make improvements a good investment, says mortgage advisor Casey Fleming, author of 鈥淭he Loan Guide: How to Get the Best Possible Mortgage.鈥�
It鈥檚 better聽to pay for these upgrades in cash, but Fleming says chances are good that you鈥檒l recoup the costs of a聽聽by investing the equity you tapped into improving your home.
Keep in mind that not all upgrades will give you a strong return on your money. Adding a new bathroom, updating flooring, or remodeling an outdated kitchen, for example, will likely boost the value of your home and help you rebuild your equity. Adding a deck or undertaking a high-end basement remodel may not.
Be careful with revolving debt
Sure, a cash-out refinance might result in a lower interest rate than your current mortgage, and can help you聽pay off your credit card balances. What you鈥檙e really doing, though, is lengthening the time frame to pay off the revolving debt 鈥� often to 30 years 鈥� which means you鈥檒l pay interest for a longer time, Fleming says. Perhaps even more problematic: You鈥檒l land yourself back into a tight spot if you run up your credit cards as soon as you pay them off.
The key to making cash-out refinancing work in your favor is discipline. If you鈥檙e conscientious about your spending and can curb credit card usage, then it can make financial sense to roll existing revolving debt into a cash-out loan, says Michael Mullin, branch manager of First Priority Financial in Bend, Oregon.
Never use a cash-out refinance for聽short-term wants
Eying a shiny new Lexus or envisioning yourself lounging on a beach in Bali? Those are nice dreams, but you shouldn鈥檛 use your home as collateral to help pay for them.聽
Consider this: Cash-out refinancing entails聽long-term interest payments, thousands of dollars in closing fees and perhaps mortgage insurance (if you have less than 20% equity in your home when all is said and done). If your income and savings can鈥檛 cover a new car or vacation, and you borrow to fund them, you鈥檒l overpay dramatically for short-lived enjoyment.
If you鈥檙e consistently spending beyond your means, using a cash-out refinance聽is like putting a Band-Aid on a much deeper wound, experts say. And if you lose your job or face another life emergency, and can鈥檛 make your mortgage payments, you could lose your house and damage your credit. Is that dream vacation or the new car really worth that kind of risk? Probably not.
Be prepared for tighter requirements
Cash-out refinancing isn鈥檛 free money, and lenders view it as riskier than a typical refinance. That鈥檚 why cash-outs have聽more stringent requirements, says Heather McRae, senior loan officer with Chicago Financial Services in Chicago.
McRae says many lenders have the following requirements for cash-out refinance customers:
- A credit score of 740 or higher (to get the lowest interest rate)
- A debt-to-income ratio below 45%
- A stable two-year work history
- A max loan-to-value limit of 80% (for a standard rate or term loan, you can borrow up to 95%)
Bottom line
Cash-out refinancing is one of many ways you can聽use your home鈥檚 equity. But as we learned in the housing downturn and Great Recession, home values can rise and fall dramatically and viewing your house as the solution to your financial problems聽might not be the wisest financial move.聽
If you鈥檝e received聽a major medical bill or need to pay your child鈥檚 college tuition, there are alternatives to using your home as collateral for quick cash. Consider asking聽your creditors for聽a low or no-interest repayment plan. You never know until you try.
Using cash-out refinancing for value-added home improvements can be a good use of your equity. Consolidating high-interest revolving debt can, too, but only if you stay disciplined and don鈥檛 run your card balances up again.聽聽to see if cash-out refinancing is the right move for your situation and financial goals.
This article first appeared at .
