When is a Cash-Out Refi a Good Idea?

With a cash-out refinance, besides refinancing your current mortgage, lowering the rate, and possibly changing the term, you can also convert some of your home’s equity to cash. Gaining access to extra funds at a low interest rate could be a good option if you use those funds wisely. Today, we’ll talk about the basics of this type of home loan, including the pros and cons. Read on to see if a cash-out refi is right for you.

The Recent History of Cash-Out Refinances

Historically, cash-out refinances hit a peak in 2006 when the real estate market was booming — right before the housing crash. The housing bubble burst because of bad lending practices. Since then, there have been safeguards, including stricter credit and appraisal guidelines.

If you or your parents lived through the Great Recession, you’d recall the rough financial times our country experienced for a few years. Because of that, you may be more conservative regarding mortgage loans, leverage, and taking out your equity. Being conservative with your finances is smart — especially when your primary residence secures the loan. That’s why, before taking cash-out, it’s essential to look at the pros and cons.

The Rising Real Estate Market

When property values are steadily increasing, you may be more interested in tapping into your home’s equity. There are several ways to do this. You can replace your existing mortgage with a cash-out refinance. Or, you can get a home equity loan or home equity line of credit (HELOC).

According to the Black Knight Home Price Index, home prices grew at an annual rate of 10.8% by the end of 2020. And, so have the number of cash-out refinances, but not anywhere near what they were in 2006.

80% Cash-Out LTV Rule of Thumb

A ratio that guides lending is loan-to-value. For your primary mortgage, you want to keep your loan-to-value at 80%. When you retain 20% equity, you avoid private mortgage insurance (PMI).

Over the last few years, more homeowners have been taking advantage of low-interest rates and increased equity by getting a cash-out refi. But, based on Freddie Mac’s Quarterly Refinance Statistics, compared to 2006, many homeowners are retaining more of their equity.

Benefits of Refinances & Cash-Out Refinances

What are the advantages of a cash-out refi? If you can lower your interest rate a point or more and use your equity to your benefit — this type of home loan might be right for you. Keep in mind, when you take cash out, you’ll be increasing your loan’s principal.

But, if you take that money and invest it back into your home, it could be worth it. You can improve your property value, even more, when you plan home improvements and renovations with the highest return on investment.

How much you can save each month by refinancing depends on your mortgage loan balance, current interest rate, property location, and whether you take cash-out and increase your mortgage balance.

In Freddie Mac’s 2020 refinance report, you can see the average annual savings based on location. Whether you're doing a rate-and-term refinance or getting cash-out, start by checking rates at your credit union. You may find that credit union rates are often lower than banks since they’re non-profit.

What Can You Use a Cash-Out Refinance For?

With a cash-out refi, you can use the money in any way you want. Here are the most common uses:

• Home Improvement — The advantage of using your funds for home improvement is that you’re reinvesting your money. And if you choose projects wisely, you’ll increase the equity in your home.
• Debt consolidation — Using the equity in your home can make a positive change in your monthly budget. But, it’s essential to make sure you change your spending habits, so you’re not in the same situation in the future.
• Paying off Credit Card Debt — Just as with debt consolidation, paying off high-interest credit cards can give you relief. Keep in mind, though, the term of your mortgage may be much longer than your credit cards, so in the long run, you might be paying more interest.
• Paying off Student Loans — If refinancing student loans isn’t an option, paying them off with a cash-out refi might be. But beware of the risks because you’re converting unsecured student loans and securing them with your home.
• Paying off Personal Loans — Many banks and credit unions offer personal loans. Sometimes they’re called home improvement or debt consolidation loans. These are unsecured. If you pay them off with your cash-out refinance, you will be securing them with your home. You have to weigh the pros and cons.
• Investing in Another Property — Using your equity to purchase another property or as a down payment can be a smart move. That is if you know what you’re doing. If you’re walking into equity or have an immediate renter, that reduces your risk.

Your home equity is an asset. When you use it wisely you build your net worth. When comparing a rate-and-term refinance with a cash-out refinance, it helps to use a mortgage calculator.  Besides looking at the change in monthly payments, it’s also wise to look at an amortization schedule to compare how much interest you’ll pay if you choose to consolidate debt.

Does Cash-Out Refinance Cost More?

Cash-out refinance rates are higher than if you don't get cash out. Sometimes it’s worth it. Other times it isn’t. That’s where it helps to use a mortgage calculator and consult an amortization schedule. Mortgage rates can also vary between financial institutions, so shop a few different mortgage lenders. No one wants to pay a higher interest rate if they don’t have to.

You can also compare doing a rate-and-term, and once it closes, get a separate personal loan for home improvements or debt consolidation. The advantage is that your home doesn’t secure this type of loan. The disadvantage is the interest is higher.

If you need a larger loan amount, especially for home improvements, consider a HELOC. Although the rate isn’t as low as what you'd get with a mortgage refinance, it’s lower than other types of loans.

Should I Take Cash Out When Refinancing?

Whether you should take cash out in a lump sum or just do a simple refi is up to you. It’s crucial to weigh all of your options and compare the short-term and long-term benefits and risks.

Generally, if you can lower your interest rate by 1% or more, it’s worth it as long as you’re planning on staying in your home for at least three years. Consider a streamlined refinance if you don’t need cash out and have an FHA or VA loan.