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A cash-out refinance is a way to borrow money using your home as collateral. Putting your home on the line comes with more risk than other types of loans that don't require collateral, but a cash-out refinance can also be a relatively inexpensive way to get a loan and may provide tax benefits. Here's what you need to know before you apply.
What Is a Cash-Out Refinance?
A cash-out refinance is a loan that replaces your current mortgage with a new, larger mortgage—giving you the difference in cash. To get a cash-out refinance, you'll need to have equity in your home; in other words, your home will need to be worth more than you owe on it.
For example, if your home is worth $300,000 and your current mortgage balance is $200,000, you have $100,000 in home equity. Because lenders don't typically allow you to borrow all that equity (equity loans are usually limited to about 80% of the home's value), you may be able to get a cash-out refi for $225,000. From the new mortgage, $200,000 will go to pay off your existing debt, and you'll receive the other $25,000 in cash.
Cash-out refinances are often used to pay for home repairs and improvements, to refinance higher-rate debts or to pay for college. Unlike a home equity loan or HELOC, where you keep your current mortgage, you'll entirely replace your current mortgage with a cash-out refi.
This can be a particularly enticing option if interest rates have fallen, as you can benefit by lowering your interest rate on all your current mortgage debt (and thus pay less over the life of the loan). It also may provide a cheaper source of funding than an unsecured loan such as a personal loan.
When Does It Make Sense to Use a Cash-Out Refinance?
A cash-out refi may make sense if you have a specific reason to borrow money and can qualify for a mortgage with a better interest rate than you currently have. Here are some reasons to consider a cash-out refi:
- You qualify for a lower interest rate. Even if you're not interested in taking cash out, you may want to consider refinancing your mortgage if you can get a lower interest rate. Mortgages tend to carry high balances and have long repayment periods, so even a small interest rate drop can lead to significant savings. If you reset the repayment term to the same number of years as your previous mortgage, your monthly payment may also drop—but you could wind up paying more interest overall due to the longer term and larger debt.
- You want to pay off high-rate debt. If you have other loans or credit card debt that you're working to pay off, using a cash-out refi to get a low-rate loan and paying off your current debts could save you money. This is only a good strategy if you can commit to not running up your card balances again after paying them off.
- You want to renovate or repair your home. Planning to use the money from a cash-out refinance to repair, maintain or improve your home could be a good move, as the money can help protect (or improve) the home's value. Using the money this way may also allow you to claim a tax deduction for the interest on the cash-out portion of your mortgage.
- You want to use the money to pay for college. Low interest rates and a manageable additional monthly payment can make this an attractive option for covering tuition and other college expenses.
The Downsides of a Cash-Out Refinance
Cash-out refinancing can also be risky and expensive. Consider these drawbacks:
- You're taking out a larger loan against your home. Even if you can lock in a lower interest rate, taking on more debt means it may be more difficult to pay off your mortgage. In the meantime, you risk losing your home if you aren't able to afford your payments in the future.
- You'll pay closing costs. Similar to when you took out your original mortgage, the closing costs on a cash-out refi can range from about 2% to 5% of the total loan amount. While you may be able to roll these costs into your loan rather than pay for them out of pocket, they'll increase your cost of borrowing. Compare your total fees and interest on a cash-out refi to the cost you'd pay to get a loan elsewhere.
- You may have to pay for private mortgage insurance. If your cash-out refi results in the total loan being more than 80% of the home's value, you may have to pay for private mortgage insurance (PMI). The extra insurance can increase your monthly costs, but it doesn't help you—it protects the lender if you don't repay your mortgage. However, many lenders will not let you borrow more than 80% of a home's value for a cash-out refinance, so this may not be a concern.
As with all types of loans, there's also the risk of borrowing money to enable a lifestyle that's outside your means. This can be especially harmful if you use the money to pay off high-rate credit card debt, but then wind up maxing out your credit cards again.
Cash-Out Refinance Alternatives
If you're looking to borrow money but don't want to (or can't) use a cash-out refi, consider some of the alternatives:
- Personal loan: You may be able to get an unsecured personal loan without using any of your assets as collateral. If you have excellent credit, some lenders may even offer rates similar to what you could find with a mortgage. But even if you can't qualify for the best rates, it may be worth paying a slightly higher rate for an unsecured loan.
- Home equity loan or home equity line of credit (HELOC): With these loans, you use your home as collateral to get a loan or line of credit without having to replace your current mortgage. Like a cash-out refinance, the terms of these second mortgages also depend on the value of your home and how much equity you have, along with your creditworthiness. These options may have fewer closing costs, and they could be a better option than refinancing if you can't qualify for a lower rate on your mortgage.
- Auto title loan: Rather than using your home, you may be able to use a vehicle as collateral to get an auto title loan. However, these are generally a poor option as auto title loans can be expensive and you risk losing your vehicle. Some states don't even allow this type of loan.
- Balance transfer credit card: If you're looking into a cash-out refi as a way to consolidate and refinance your credit card debt, also consider a balance transfer credit card. While you might not be able to get a card credit limit as high as your cash-out amount, balance transfer cards may offer promotional 0% APR rates on transferred balances.
There are also other strategies you can use to get out of debt without taking out a new loan. For example, you could look for ways to increase your income and cut expenses and then put extra money toward your lowest-balance debts first (the debt snowball strategy). Or, with the avalanche strategy, you start with the debt that has the highest APR.
Check Your Credit Before Shopping for a Mortgage
As you're taking out a new mortgage, you're more likely to get approved for a cash-out refi with a good rate if you have good to excellent credit. Checking and tracking your credit could help you decide if a cash-out refi is a good idea right now, or if you want to focus on improving your credit to try at another point in the future. Experian offers free credit monitoring and score tracking, with alerts if there are any suspicious changes in your credit.