Often, homeowners find themselves with a conundrum: They have thousands of dollars in equity in their home and financial needs elsewhere. Many start wondering how they can tap into their home equity to solve their other financial problems.
One way to pull equity from your home is a cash-out refinance, often shortened to “cash-out refi.” It’s not fast or cheap, but it can be an effective source of funding when you need it.
Here’s what you need to know about cash-out refinances, their pros and cons, who the ideal candidate is, and what alternatives are available.
What Is a Cash-Out Refinance?
Refinancing your home involves taking out a new mortgage loan to replace your existing one. A cash-out refi is a specific type of refinance where you take out a larger loan so you can walk away from the settlement table with additional cash.
Like with a purchase mortgage, lenders look at your credit history, income, and job stability to help them evaluate your creditworthiness.
But while purchase loans require a down payment, cash-out refi lenders instead look at your existing equity, or the difference between your current mortgage balance and your home’s value.
Typically the most lenders will offer is 80% to 90% of your current home value. It’s called loan-to-value ratio, or LTV, and the higher the LTV, the higher the interest rate you should expect to pay.
Most mortgage lenders offer cash-out refinance loans. To compare several interest rates and loan quotes, try LendingTree or Figure.
Advantages of a Cash-Out Refi
There are many good reasons to consider a cash-out refi. If you have plenty of equity in your home, here are the potential benefits of refinancing and pulling out cash.
1. You Can Tap Into Equity Without Selling
Traditionally, the only way to realize equity in real estate is to sell it for capital gains. Borrowing money against your home offers another option for tapping into that equity without you having to sell your home.
You get access to the cash, and you also get to keep your home. In some cases, that makes for a win-win scenario.
2. It Offers Low, Fixed Interest Rates
The average interest rate for a 30-year fixed-interest mortgage is 3.47%, per Mortgage News Daily. The average credit card interest rate is over four times higher, at 17.21%, according to CreditCards.com.
While those individual rates fluctuate, the relationship between them changes little. Mortgages are secured against real estate, so they offer far less risk to lenders. Since lenders price based on risk, mortgages inevitably cost a fraction of the interest credit cards charge.
Even better, mortgages let you lock in today’s low interest rates for the entire life of the loan. Credit cards and other rotating forms of credit rise and fall based on that day’s interest rates.
Depending on the rates when you first bought your home or your credit at that time, you may also be able to refinance at a lower interest rate than you’re currently paying. That could potentially mean a similar monthly payment for a higher loan amount.
3. You Can Consolidate Your Debt
As outlined above, mortgages tend to be the cheapest form of credit available. If you have other forms of debt, such as credit card debt, personal loans, or student loans, it may be cheaper to roll them all into a new mortgage. It’s called a debt consolidation loan.
Beyond the possible financial benefits of a lower interest rate, it can be psychologically comforting to have one loan to pay each month rather than many scattered debts. Many borrowers start feeling overwhelmed by the sheer number of debts they owe, and they don’t know where to start tackling them.
4. It Might Improve Your Credit
One of the factors that go into calculating your credit score is the ratio of consumer debt you owe versus the total credit available to you. The magic number is 30%. If you owe more than 30% of your limit on credit cards, for example, it starts to damage your credit.
By paying off all those individual debts and consolidating them into a mortgage, you can potentially improve your credit. Of course, you then need to start using your credit cards responsibly if you want the improvement to last.
Consolidating debt can also improve your credit if you face a major bill you can’t pay on your own, such as a large medical bill. If your choice is between doing a cash-out refi and defaulting on a bill that will go to collections and become a judgment, you can avoid damage to your credit by pulling cash out of your home to pay the bill.
5. The Interest Is Deductible
Mortgage interest is tax-deductible. The interest on credit card balances and most other forms of debt? Not so much.
By consolidating your debts under your mortgage, you can save on taxes by deducting the interest.
Keep in mind that this only applies if you itemize your deductions, however. If you take the standard deduction rather than itemizing, it doesn’t help you. And given how much the standard deduction grew as a result of the Tax Cuts and Jobs Act of 2017, fewer Americans are itemizing their deductions.
6. You Can Leverage Cheap Financing to Invest Elsewhere
The current median home value is $231,000, according to Zillow. If you borrow 90% of that ($207,900) as a cash-out refinance at the average interest rate of 3.72% for a 30-year term, you can expect to pay $137,440.80 in interest over the life of the loan.
Now imagine you invested that $207,900 at 8%, which is in line with historical returns for the stock market or investment properties. At the end of 30 years, that investment would have compounded to $2,092,026.37. That’s without investing another cent and simply allowing the returns to compound.
It’s how banks make their money: They borrow money at a low interest rate, such as what they pay you for your savings account, and then they lend it at a higher interest rate, such as what they charge you for your credit card balance.
If you can borrow money at 3.72% and invest it at 8%, then you come out far ahead in the long term.
7. You Can Avoid Capital Gains When You Want to Move
Imagine you own a high-value property, and you’re planning to move to a new home.
You could sell it, and your first $250,000 or $500,000 will be exempt from capital gains taxes, depending on whether you’re single or married. But gains above that threshold mean paying taxes on your proceeds.
Instead of selling, you could keep your old house as a rental property. Once again, you can pull out the equity in it with a cash-out refi and keep the property. You get to walk away with most of your equity in cash, and then your tenants can pay down your new mortgage for you.
It’s a more advanced maneuver and not without its risks. In particular, you need to run the cash flow numbers carefully to make sure you still come out ahead each month, even after non-mortgage expenses.
But for high-net-worth homeowners looking to build passive income and avoid taxes on gains, it can make for a clever tactic.
Drawbacks of a Cash-Out Refi
Refinancing comes with plenty of downsides, in addition to the advantages above. Before refinancing your home to pull all the equity out, weigh these drawbacks carefully.
1. You Face a Higher Monthly Payment
A higher monthly mortgage payment means higher living expenses, which come with a host of cons.
First, it means you need to earn more money to pay your bills. It’s one reason why higher debt means higher risk: If your income takes a hit, you may not be able to make your payments.
And that’s not just now, while you’re an active income earner. If you’re planning for retirement, you need to be able to cover all your living expenses with other sources of income.
That usually means a combination of Social Security income, income from your investments, and (if you’re lucky) income from a pension. But the higher your monthly living expenses, the more income you need to bring in from those sundry sources.
That usually means saving more money to draw on in retirement. In other words, the higher your monthly expenses, the more you need to save to retire.
2. It Extends Your Debt Horizon and Total Interest
Decades into the future seems like an eternity. For most of us, the difference between 20 and 30 years from now is purely conceptual, so it’s easy to just lump it all together as “some time in the distant future.”
But the consequences in costs are very real.
Say you bought your home 10 years ago and took out a 30-year mortgage at 4% interest for $200,000. After 10 years of making payments, you’ve paid more than half the total life-of-loan interest.
Of the $143,739 total interest owed on the loan, you’ve already paid $72,673, and over the following 20 years, you’ll pay another $71,066 — if you keep your current mortgage.
Now, imagine you refinance your loan, borrowing $250,000. You go from having a principal balance of $157,138 with 20 years and $71,066 left in interest to go to having a $250,000 loan balance with 30 years and $179,674 in interest to go.
That’s 10 more years of debt and over $108,000 in additional interest to pay.
After closing costs (more on those below), you’d be lucky to walk away from the settlement table with $90,000 in cash. But your total outstanding principal and interest would explode from $228,204 ($157,138 principal plus $71,066 remaining interest) to $429,674 ($250,000 principal plus $179,674 interest).
To borrow $90,000, it costs you an extra $201,469, plus another 10 years of debt. Does that sound like a good deal to you?
3. You Restart the Amortization Schedule From Scratch
If the math above left you scratching your head, you’re not alone. The reason it’s so counterintuitive is due to how mortgages are repaid, which is known as “simple interest amortization.” It’s anything but simple.
Here’s how it works: At the beginning of your loan, nearly your entire monthly payment goes to interest (in other words, profit) for the lender. As time goes by, gradually more of each monthly payment starts going toward paying down your principal balance.
In the last few years of your loan term, most of your payment goes toward principal, so it’s only at the very end of your loan that you actually start paying it down fast.
Amortization is why, in the example above, you’d paid more than half the total life-of-loan interest when you were only 10 years into a 30-year loan, but you’d only paid your principal balance down from $200,000 to $157,138.
In short, you don’t want to restart your amortization back at square one because it means going back to paying mostly interest and very little principal with each monthly payment.
4. You Incur Closing Costs
Loan officers are quick to tell you not to worry about closing costs — that they’ll just roll them into the loan. The result is that not-so-savvy borrowers pay little attention to all the fees and points the lender charges to do their cash-out refinance.
Lender fees start with the origination fee, usually referred to as points. One point equals 1% of the total loan amount. Points add up quickly. For example, 2 points on a $250,000 mortgage comes to $5,000.
Lenders also charge junk fees, such as processing fees, underwriting fees, appraisal review fees, and document preparation fees. These are flat fees to make each loan more profitable for the lender.
Plus, you pay non-lender fees at closing, such as title fees, wire transfer fees, and recording fees.
Expect the closing costs on a cash-out refinance to cost you thousands of dollars. You just won’t feel the bite of them since they’re rolled into the loan and you don’t have to write a check for them at closing.
5. Mortgage Insurance (PMI/MIP)
If you borrow more than 80% of your home’s value, expect to pay extra each month for mortgage insurance.
The nomenclature varies, depending on the loan type. Conforming loans call it private mortgage insurance (PMI), while FHA loans call it mortgage insurance premium (MIP).
Whatever your lender calls it, it’s all downside for you. You have to pay for insurance that protects the lender, not you. If you default on your loan, the insurance covers any losses suffered by the lender.
Avoid mortgage insurance because it’s lost money.
6. Risk of Foreclosure
When you default on your credit card debt or student loans, the worst the creditor can do is file for a judgment. But if you default on your mortgage, the lender forecloses and takes your home.
It’s why the interest is so much lower on mortgages compared with unsecured debts. The lender has far greater recourse and collateral to collect their debt.
Keep it in mind the other edge of the sword of lower interest rates: The risk to you and your assets is far higher.
7. It Can Enable Bad Spending Habits
Imagine you run up $30,000 in credit card debts. Suddenly, you feel overwhelmed looking at the massive stack of debt you’ve accumulated. So you refinance your home to spread that debt over the next 30 years. Problem solved, right?
Sort of. Except now you’re hit with thousands of dollars in closing costs and potentially hundreds of thousands of dollars in additional principal and interest due over a longer time horizon.
Worst of all, there’s nothing to stop you from doing it all over again. With newly full lines of credit on all your credit cards, you’re free to let the spending spree continue.
Who Should Consider a Cash-Out Refinance
There are very specific situations in which a cash-out refinance makes sense.
The first is when you plan to invest the cash you pull out of your home. For example, as a real estate investor, I’ve seen many of my colleagues leverage their home equity to use as down payments for investment properties.
The math can work. In some cases, real estate investors can earn 10% to 20% returns on rental properties and dramatically higher returns from flipping houses — all while borrowing money at 3.5% to 4% against their home.
They’re also professional investors.
Along similar lines, it sometimes makes sense for small-business owners to borrow money against their homes to grow their businesses. Ideally, that growth is based on a proven track record. The entrepreneur knows how to scale their business through strategically investing in expanding their marketing, team, or inventory.
It can also make sense to pull cash out to invest in yourself personally. If a new certification or degree will dramatically improve your income potential, and the only way you can afford it is by refinancing your home, then it may well be worth the effort.
Some homeowners refinance their homes to afford home renovations. One example of a home improvement that sometimes makes sense to finance is adding an accessory dwelling unit, which can quickly pay for itself in rental income.
But while some home improvements can boost your home’s value, no single renovation adds more value than it costs on average, according to Remodeling Magazine.
Still, if you plan to do the repairs yourself, or you have an inside connection with a contractor who can do the work inexpensively, you may see a positive return on investment.
There’s also an argument to be made for a debt consolidation refinance, but the costs can easily outweigh the benefits. Instead, try the debt snowball or debt avalanche methods to pay off your debts in rapid succession.
Who Should Avoid a Cash-Out Refinance
The short answer to who should avoid cash-out refinancing is: everyone else.
Taking on more debt is rarely the answer to your financial problems. There is such a thing as good debt versus bad debt, and it comes down to whether the debt makes you richer or poorer.
Debt you use to invest in income-producing assets, such as rental properties, qualifies as good debt as long as your returns outpace your costs. Likewise, debt you use to invest in your future income potential qualifies as good debt.
But debt used to buy things you can’t afford in cash? That’s bad debt. Consumer goods, travel, home renovations —if you have to go into debt to have them, you probably can’t afford them.
Alternative Funding Sources
Cash-out refinances sometimes make sense financially. But even when they do, there’s often a more cost-effective way to achieve the same result.
Here are several alternatives to explore before calling up your loan officer and inviting a sales pitch.
1. Second Mortgage
Detractors point out that second mortgages, also known as home equity loans, charge higher interest than cash-out refinances. And they do.
But they also don’t require you to restart your amortization schedule, extend your debt horizon, or pay off your current mortgage.
Second mortgages tend to be small mortgages, and you can always pay them off early. If you truly want to get a new mortgage, consider a smaller second mortgage rather than refinancing.
2. HELOC
Have a quick need for cash you expect to pay back relatively quickly? Often, a home equity line of credit, or HELOC, proves a better option than either a refinance or a second mortgage.
HELOCs are flexible, letting you pay off the balance and then draw on it again as you need it. In some ways, they work like a credit card, but with a lower interest rate because the credit line is secured against your home.
I’ve known real estate investors to use their HELOCs to draw the down payment for each new property they buy. After buying, they quickly pay the HELOC balance off. Then, they rinse and repeat indefinitely.
You can get quotes for HELOCs at LendingTree. Figure offers a hybrid HELOC/home equity loan as well.
3. Personal Loan
Personal loans charge higher interest rates than mortgages. But they also cost far less in upfront fees, don’t require you to use your house as collateral, and don’t restart your amortization schedule or mortgage debt horizon.
Look beyond interest rate at annual percentage rate (APR), which includes not just interest but also all the lender fees as a percentage of the loan you’re borrowing.
When you add up the total cost of the loan, you might just find that personal loans offer a better deal.
4. Business Loan
Looking for capital to expand your business?
You don’t necessarily need to remortgage your house. Instead, look into business loans. The interest rate is higher, but if you default on your loan, the lender won’t be able to foreclose on your house.
As a general rule, keep your business assets and liabilities as separate as possible from your personal assets and liabilities. Not only does it keep your accounting cleaner, but it also helps you limit the legal liability on your business losses so plaintiffs and creditors can’t come after you personally.
5. Student Loans
Likewise, if you’re looking for money to cover education expenses, consider student loans. Again, expect a higher interest rate, but the loans don’t secure your home as collateral.
There are lots of options for paying back student loans, particularly if you run into financial troubles later on. And you can always consolidate your student loans later, under either a cash-out refinance or another loan type.
6. Reverse Mortgage
If you’re at retirement age and see your home equity as a potential source of cash, a reverse mortgage is another option at your disposal.
Reverse mortgages come with their own quirks, pros, and cons. You have no monthly payment; in fact, the lender typically sends you money every month.
But even if you reach the limit of your equity and lender payouts, the lender cannot foreclose on you. The loan simply goes dormant until you sell the house or pass away, at which time the loan comes due.
7. Credit Cards
You can do amazing things with credit cards. I once bought and renovated an investment property with a credit card.
Alas, they’re also far too easy to abuse. That’s the point. Credit card companies want you to rack up debt and keep a balance so they can keep charging you high interest month after month.
But the savviest consumers can pull all sorts of neat tricks to save on interest, reap rewards, and pay down their debts quickly.
For example, many credit cards allow you to transfer your existing balances to them, with an initial 0% interest phase that’s sometimes as long as 18 months. With aggressive debt repayment, you can often knock out that debt before the card starts charging interest.
You can also use creative tactics to pay your student loans back with credit cards. Just be careful not to dig yourself even deeper into debt. The point is to get out of debt as quickly as possible, not to borrow from Peter to pay Paul.
8. Pay Debts and Bills the Old-Fashioned Way
No one likes hearing it, but the cheapest way to pay for anything is in cash.
If you have balances on three credit cards, a student loan, and a medical bill, use the debt snowball or debt avalanche method to simply pay them off one at a time.
Every time you knock one debt out, put all your additional resources into paying down the next until you’re debt-free — or you’ve at least paid off all your unsecured debts.
Likewise, if you want a new kitchen, save up the money and pay for it in cash. You can always cheat a little with credit cards if you like, but at least you won’t take on all the fees and long-term debt problems that come with refinancing your mortgage.
Instant gratification is a recipe for debt and poverty. Learn patience, discipline, and deferred gratification, and you’ll find yourself a far wealthier person in a few short years. You’ll also be a happier person without the stress of managing long-term debt.
Final Word
In the aftermath of the Great Recession, pundits accused American homeowners of “using their home like an ATM.” They had a point.
Far too many homeowners saw their home values skyrocket and started seeing dollar signs when they realized how much equity they had in their homes. It was theirs, after all. Why shouldn’t they get to spend it?
The simple truth is that real estate equity only exists on paper. The only true way to realize it is through selling. You can borrow money against it as collateral, but it’s only that: collateral for a debt.
Before inviting a loan officer to pitch you on a cash-out refinance, ask yourself two simple questions: Do you really want more debt? Is it worth signing a 30-year legal commitment just to get to spend more money today?
There are a few good reasons to take out a cash-out refinance. But they all share one thing in common, and that’s investing the borrowed funds to make yourself richer, rather than spending money that isn’t yours to become poorer.
If you can’t mathematically prove to a disinterested third party that your use for the debt will make you richer, look for other ways to pay for whatever it is you want the money for.
Your future self will thank you when you’re not yoked to debt for decades to come.
