Is a cash-out refinance a good idea?
The number of cash-out refinances vs. ordinary refinances fell sharply in 2020. Yet one of the key benefits of cash-out refinancing is that it’s typically the least expensive way to borrow a large sum of money. So what’s going on?
It’s likely that many Americans are spooked by economic uncertainty during the COVID-19 pandemic.
But others may be put off from a cash-out refi because home equity borrowing gets a bit of a bad rap historically.
If you’re wondering whether a cash-out refi is a good idea, here’s what you should know about the benefits and how to do it safely.
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What are the benefits of cash-out refinancing?
If you need to borrow a large sum of money, and you have plenty of home equity, a cash-out refinance is often the cheapest way to do it.
A cash-out refinance lets you borrow against the value of your home. Since these are ‘secured’ loans — meaning the house is used as collateral — they have much lower interest rates than other forms of borrowing.
For example, current mortgage interest rates for someone with strong credit are around 3% — whereas personal loan rates range from about 6% to over 20%.
Low interest rates aren’t the only reason to consider a cash-out refinance, either.
Benefits of cash-out refinancing
- You could lock in a lower interest rate on your mortgage
- You can use the funds for any purpose; debt consolidation and home improvements are popular uses
- You don’t need a specified purpose for the funds; you can even put them toward things like emergency funds and investments
- You have the option to shorten your loan term or change loan programs when you refinance
Generally, a cash-out refinance is worth it if you need cash and you can benefit from refinancing your existing loan.
Putting the funds to good use could even improve your overall financial situation.
For example, debt consolidation can give you a fresh start if you find yourself with high credit card balances or other high-interest debts. And, provided you don’t run those up again, you could save hundreds each month and transform your finances.
Many homeowners also use cash-out funds to make home improvements that increase the value of the property and net a bigger profit when they eventually sell. In this way, they see a great return on their refinance.
But of course, a mortgage refinance isn’t the right decision for everyone.
Drawbacks of cash-out refinancing
- There are closing costs (typically 2%-5% of the new loan amount)
- You re-start your mortgage term, usually for another 15 or 30 years
- If your home’s value drops, you could owe more on your mortgage than the home is worth
- If you can’t make loan payments, you could face a foreclosure
The risks of cash-out refinancing are similar to any mortgage: if the loan defaults, your home is on the line.
But there’s a little more to consider here, because with a cash-out refi, your new loan amount is higher than your current mortgage. Your monthly payments could potentially be higher, too.
Who should consider a cash-out refinance loan?
These drawbacks mean a cash-out refinance typically isn’t best if you only need a small amount of money, or if you won’t see a return on your investment (like using a cash-out refi to pay for a vacation or a new car).
Refinancing typically isn’t ideal if you’re close to the end of your mortgage term, either.
But if you can benefit from a refi and you’ll put the funds to good use, a cash-out refinance can be a very smart way to finance big expenses.
With today’s real estate values on the rise, cashing out equity is a safer prospect than it was in the past.
How rising rates affect the benefits of cash-out refinancing
2020 was an amazing time for mortgage rates.
Average 30-year rates hit 16 new all-time lows that year. And 2021 kicked off with another record low of 2.65% on January 7, according to Freddie Mac.
But then interest rates started to rise. At the time this was written, they were close to 3%.
Of course, there’s always a chance rates could drop again. But it’s more likely they’ll go higher. Check out today’s mortgage rates to see.
Rising rates could make a cash-out refi less attractive to many homeowners in the near future — especially those who already have a low rate, and could potentially increase their mortgage payments and interest cost by refinancing.
If rates go up substantially, it may be better to leave your current mortgage in place, and opt for a home equity loan or HELOC. That way you’re paying a higher rate on a smaller loan amount, and you leave your current mortgage intact.
If you’ve been on the fence about a cash-out refinance, now’s probably the time to get serious about applying.
Who can cash out home equity?
Pre-housing crash, it was far easier — almost too easy — to cash out home equity. That’s part of the reason these loans sometimes get a bad rap.
But those days are gone. Today, you can expect lenders to comb through your personal finances before giving you the green light.
This makes it tougher to get approved for a cash-out mortgage loan than in the past, but it also protects homeowners from unsafe borrowing.
Most lenders have the following minimum requirements for a cash-out refi:
- You must retain at least 20% equity — That means you can borrow the difference between your mortgage balance and 80% of your home’s market value, which will be reappraised for the loan
- You need a credit score of at least 620 — The higher the better, as you could get approved for a lower mortgage rate
- You need reliable income and employment — Lenders want to see you can easily afford the new loan’s monthly payments
- Your DTI is below 43% — Your monthly debt payments (housing costs, credit card debt, student loans, child support, etc.) take up no more than 43% of your gross monthly income. This is your debt-to-income ratio or ‘DTI’
Of course, it’s your job to make sure you can comfortably afford your new loan. But, if you can clear these hurdles, you may well be in good enough financial shape.
Why cash-out refinances have declined
Low mortgage rates made home buying and refinancing incredibly popular in 2020.
In fact, mortgage debt jumped by $182 billion just in the last three months of 2020, according to the Federal Reserve Bank of New York.
And yet, Freddie Mac reckons the share of cash-out refinances was way down in 2020.
True, some of that may be a result of the larger total number of refinances skewing the math. But the fact remains: cash-out loans accounted for only 35% of all refinancing transactions across the first nine months of 2020. And that compares with 52% in 2019 and 76% in 2018.
So, what’s the reason for the decline?
The coronavirus pandemic
Judging from other data concerning debt, it may be that borrowers are holding back on ‘unnecessary’ debts across the board during the pandemic.
The Federal Reserve’s G.19 report, which shows trends in consumer credit, says store and credit card balances (“revolving credit”) tumbled 11.2% in 2020. That’s $118.3 billion less debt sitting on plastic.
Meanwhile, the New York Fed calculates that balances on home equity lines of credit (HELOCs) saw a $13 billion decline that year.
So it may be that homeowners have been scared straight by the pandemic, and are limiting their borrowing during these uncertain times.
A spotty reputation for cash-out loans
In the early 2000s, cash-out refinances accounted for between 80% and 90% of all refinances, according to a Refiguide analysis based on Freddie Mac data.
Some people were using their homes as ATMs to prop up unsustainable lifestyles. Others were persuaded into a cash-out refi by unscrupulous lenders looking to turn a profit.
Whatever the motivation, these high cash-out numbers likely played a role in the Great Recession.
As Wharton finance professor Nikolai Roussanov says, “people had borrowed a lot against their homes when house prices were rising. And when house prices collapsed, they ended up having these unsustainably large debt burdens.”
But that was then and this is now.
Yes, it’s still a bad idea to use cash-out refinancing to live beyond your means.
But, if you need money for something serious, and you’re borrowing responsibly, cash-out refinancing may well be your best way forward.
Cash-out refinances vs. other forms of borrowing
We’ve said a couple of times that cash-out refinances are great for borrowing large sums. But, unless you want to refinance anyway (perhaps you can reduce your mortgage rate and monthly payment), they’re a terrible way to borrow small amounts.
That’s because a cash-out refinance is a whole new mortgage. And you have to pay closing costs, just as on your existing mortgage.
Given that upfront fees are typically 2%-5% of the mortgage’s value, that’s likely to be several thousand dollars. And paying thousands to borrow just a few thousand doesn’t make financial sense.
Home equity loans (HELs)
Like a cash-out refi, a home equity loan lets you borrow a large lump sum from your equity.
Home equity loans also usually have closing costs in the 2%-5% range. But you pay those only on the amount you’re borrowing (not the full mortgage amount). So the total cost will be lower. And, these loans have only slightly higher interest rates than cash-out refinancing.
Meanwhile, home equity loans have another advantage over cash-out refinances. Namely, you don’t reset your mortgage term.
Unless you opt for a shorter term, refinancing means you end up paying for your house over a longer period.
Suppose you’ve had your home 10 years. And you refinance to a new 30-year mortgage. You’ll be paying your home down over 40 years. And that’s 40 years of paying interest, which isn’t cheap, no matter how low rates are.
A home equity loan avoids that issue by leaving your current mortgage intact.
Home equity lines of credit (HELOCs)
A home equity line of credit (HELOC) is a bit like a credit card in that you’re given a credit limit and can borrow up to that sum. You pay interest only on your outstanding loan balance, and can borrow, repay, and re-borrow as often as you wish.
Like HELs, HELOCs are second mortgages. But, unlike HELs, they tend to come with small or zero closing costs. So these are a better way to borrow smaller sums — or large ones over a brief period. Interest rates are typically a bit higher than for HELs.
For most borrowers, rates on personal loans are appreciably higher than for cash-out refinances, HELs, and HELOCs.
However, a few lenders offer personal loans to the very best borrowers (stellar credit scores, high incomes, and lots of assets) at similar rates.
The upside is these are “unsecured” loans, meaning they’re not tied to an asset. So, unlike with mortgages and second mortgages, you’re not putting your home on the line if things go wrong.
Explore your options and interest rates
Cash-out refinances are safer and more affordable than they were years ago.
It’s likely you’ll be able to take cash out no matter what type of mortgage you have. These loans are commonplace for conventional, conforming, FHA and VA loans. Only USDA loans ban cash-out refinancing.
Of course, while you’re at it, you should fully explore your refinance options.
For example, why stick with an FHA loan when you could refinance to a conventional one without private mortgage insurance?
And, naturally, you should shop around between multiple lenders to make sure you get the full benefits of cash-out refinancing, including the lowest possible rate and loan costs.