It’s important to understand the pros and cons of a cash-out refinance before you take on more debt.
A cash-out refinance can help you take advantage of your home equity without having to move. Home values in the U.S. have soared since the start of the pandemic, so you might be sitting on more equity than you ever imagined.
Still, a cash-out refinance isn’t always the best way to access your home equity, and sometimes you might be better off not borrowing at all.
What is a cash-out refinance?
A cash-out refinance is a mortgage refinance loan that allows you to access the equity you’ve built in your home as you paid down your mortgage principal, your home’s value appreciated, or both.
Let’s say you bought your house for $250,000 and you’ve paid your mortgage down to $150,000. Your house appreciated in value and is now worth $300,000. Your equity is 50%, or $150,000. Lenders generally only allow you to borrow against 80% of your home’s value, so, in this case, you’ll be able to get a new loan for $240,000 and cash out $90,000.
How does a cash-out refinance work?
A cash-out refinance replaces your existing mortgage with a new, larger mortgage. You get the difference in cash after subtracting closing costs.
You’ll typically receive your lump sum through a wire transfer to your bank account after closing, and you can use that money however you’d like.
Learn More: Reasons for a Cash-Out Refinance: How to Use Your Home Equity
Pros of a cash-out refinance
Cash-out refinancing has several benefits that make it an appealing option for homeowners.
Lower interest rates
If interest rates have decreased since you took out your first mortgage, cash-out refinancing can help you secure a lower rate. Plus, with the same loan, you’ll get to access your equity.
Tip: The interest rate on a cash-out refinance will usually be lower than what you’d pay for a home equity loan, credit card, or personal loan.
Large loans
A cash-out refinance may allow you to borrow more than you could with a personal loan or credit card. Since the loan is secured by a valuable asset — your home — mortgage lenders are typically generous with borrowing limits.
Good to know: A home equity loan or line of credit, also called a second mortgage, has the same benefit.
Read: Using a Cash-Out Refinance to Buy a Second Home: A Good Idea?
Tax benefits
Home mortgage interest on loans up to $750,000 is tax deductible when you use the money to buy, build, or substantially improve your home. (Refinancing counts, too.)
Refinancing into a larger loan and restarting your loan term, especially if you get a 30-year mortgage, may increase how much mortgage interest you pay each month, though some of this increase will be offset if you’re getting a lower rate.
Important: Most people either claim the standard deduction or see only a small benefit from itemizing. Things may change after 2025 when the higher standard deduction created by the Tax Cuts and Jobs Act in 2017 expires unless Congress extends this change or makes it permanent.
Check Out: Cash-Out Refinance Tax Implications
Longer payment period
With a cash-out refinance, you’ll have up to 30 years to repay the loan. In addition, refinancing allows you to restart the clock on your mortgage, which can help offset the potential increase in your monthly payment. Getting a lower interest rate can also help lower your monthly payment.
Tip: If you do a cash-out refinance without extending your loan term, your payment may increase since you’re borrowing more and repaying it over the same number of years. However, a shorter term will cost you less in mortgage interest.
If you’re considering a cash-out refinance, be sure to look at as many lenders as possible. Credible makes finding the best deal easy — you can compare multiple lenders and see prequalified refinance rates in as little as three minutes.
Cons of a cash-out refinance
If you only look at the pros, cash-out refinancing might sound ideal. However, there are drawbacks as well.
Interest costs
Cash-out refinance loans often have slightly higher interest rates than your standard rate and term refinance. Since you’re borrowing more money and reducing your equity, lenders may charge more for the additional risk.
In addition, borrowing more money and extending your loan term can increase how much interest you pay over the life of your loan.
Closing costs
You’ll incur the usual closing costs with a cash-out refinance, from origination and underwriting fees to title insurance and appraisal charges. Lenders typically subtract these costs from the additional cash you’re borrowing. Closing costs are usually 2% to 5% of the loan amount, or $2,000 to $5,000 for every $100,000 you borrow.
You may be able to avoid closing costs or even get a credit at closing, but you’ll probably pay a higher interest rate in exchange for the upfront savings.
See: 8 Best Cash-Out Refinance Lenders of 2022
Foreclosure risk
Your home will serve as collateral for the cash-out refinance. If your new loan increases your monthly payment, you might have a harder time keeping up in the event your income goes down or your expenses go up. You could be at higher risk of foreclosure than if you hadn’t refinanced.
Lost equity
Cash-out refinancing reduces your equity. Decreasing your equity could put you at greater risk of ending up underwater on your loan and being unable to pay it off should home values drop and you need to sell.
Tip: You can limit this risk by cashing out only as much equity as you need, not the maximum a lender will allow.
Time to close
Cash-out refinancing can take several weeks. If you need money quickly, a personal loan or credit card may provide faster access to funds. Even if they have higher interest rates than home loans, they might be less expensive if you repay them quickly, since you won’t incur thousands of dollars in mortgage closing costs.
Should I get a cash-out refinance?
You might want to get a cash-out refinance if it will save you money, increase your quality of life, or make your monthly payment more affordable.
Cash-out refinancing might save you money if:
- You use the cash to pay off high-interest debt.
- Your new loan will have a lower interest rate than your existing loan.
- You spend the cash on preserving or improving your home’s value.
- Home equity is your least expensive borrowing option.
- It’ll allow you to expand your home instead of moving.
Cash-out refinancing might not save you money if you have a low credit score. Borrowers with lower credit scores typically receive higher interest rates. The average credit score of a homeowner who did a cash-out refinance in March 2022 was over 710, according to a Black Knight report. The minimum for a conventional loan is 620.
On the other hand, you might not want to do a cash-out refinance if:
- You want to pay off your home sooner.
- You don’t trust yourself to spend the money wisely.
- The closing costs are unreasonable.
- Cash-out refi rates are higher than your current mortgage rate.
In these cases, you might consider a personal loan, home equity loan, or home equity line of credit instead.
