Pros and cons of cash-out refinances
- A cash-out refinance converts a portion of a home’s equity into cash.
- They can be used to consolidate debts, do home repairs or pay off student loans.
- Cash-out refinances carry risks by increasing the loan amount and term.
- It makes little sense to do a cash-out refinance when interest rates are rising.
A cash-out isn’t like a traditional refinance, where the homeowner refinances to lower the rate, shorten the loan term or convert from an adjustable-rate to a fixed-rate mortgage.
Instead, a homeowner is tapping into a home’s equity to take cash out.
People often use cash-out refinances to pay off high-interest credit card balances, student loans or to make substantial renovations. If the home is valued at $400,000 and the loan balance stands at $250,000, for example, the homeowner can potentially refinance the entire loan and tap a remaining $150,000 in equity. Lenders won’t typically allow homeowners to cash out all of their equity as they once did, but will often allow the homeowner to scoop up as much as 85 percent of it. Compare lenders to find the refinance conditions you are eligible for.
Cash-out refinances can be tempting
With home values rising across the country, it is easy to see why cash-out refinances are tempting again. Sometimes a borrower can use a cash-out refinance not only to tap equity, but also to get a better mortgage rate or convert an adjustable-rate mortgage into a fixed-rate loan.
Cash-out refis should come with a warning label, however.
During the last downturn, millions of homeowners got into trouble when they refinanced their homes as home values shot up. Some borrowers took cash out multiple times, and then saw home prices plunge in their neighborhoods. In some cases, people treated their homes like checking accounts to fuel lavish lifestyles and make big-ticket purchases, believing their home values would keep going up.
When the bubble burst, millions of homeowners were left deeply underwater, owing more on their mortgages than the value of their homes. Many homeowners also lost their jobs. With little chance of selling their home and paying off their mortgaged debt, they had no choice but to default on their mortgages. Consequently, millions lost their homes to foreclosure.
The risks of a cash-out refinance
One of the largest downsides of a cash-out refinance is that it will increase the balance of the loan, and usually increase the term of the loan. This puts the borrower at risk if another downturn hits. It also usually means that a homeowner will have to increase their monthly mortgage payments.
A borrower seeking to tap equity has alternatives to a cash-out refinance. They can take out a home equity line of credit (HELOC). HELOCs are not traditional loans, but rather work like giant credit cards secured by a home’s equity. HELOCs can be set up in several ways, but the homeowner keeps their original mortgage in place.
HELOCs carry their own risks, but they also are often easier and quicker to obtain than a cash-out refinance, and can be more flexible.
In a 2016 interview with Scotsman Guide, Fannie Mae Chief Economist Doug Duncan said cash-out refinances were increasing, but only because interest rates were still low. He said cash-out refis would cease to be an option when interest rates rise, however. That’s because it makes more sense to keep the original, low-rate mortgage in place, and possibly do a HELOC to tap equity.
“If you think about the interest rate a half a point or a point above today, unless a person is moving, you think they would go for a home equity line,” Duncan said.