Here's What Happens When You Do a Cash-Out Refinance

When mortgage rates are favorable, it can often pay to do a refinance. During a traditional mortgage refinance, you borrow the exact amount of your existing loan balance, thereby swapping your old loan for a new one with different terms (ideally, terms that include a lower mortgage rate).

With a cash-out refinance, you borrow more than your remaining mortgage balance. You then get the extra money as cash that you can use for any purpose.

Here's how this might work. Let's say you owe $200,000 on your mortgage but you have a home worth $400,000. Let's also say you need $40,000 to renovate your home or do something having nothing to do with your home, like start a business.

A cash-out refinance would allow you to borrow $240,000. The first $200,000 would be used to pay off your current mortgage, and the remaining $40,000 would go to you in cash form.

In 2021, 60% of all mortgage refinances were of the cash-out variety, according to data firm Black Knight. And that makes sense, because back then, mortgage rates were very competitive.

These days, a cash-out refinance is less appealing on a whole because mortgage rates are pretty high. But it could still be a good way to tap your existing home equity.

And also, it may be that you happen to have a higher interest rate on your mortgage because you signed it at a time when your credit score wasn't great. So today's rates may actually be lower than what you're paying anyway.

That said, cash-out refinance borrowers risk falling into a big trap. And it's one you'll need to be careful to avoid.

Don't get in over your head

A cash-out refinance can be tempting because it gives you a way to use the equity you have in your home to your benefit. But because that equity can be fairly easy to access, you might end up in a situation where you've borrowed too much and begin struggling to keep up with your housing payments.

It's often the case that a regular refinance will lower your monthly mortgage payments. A cash-out refinance has the potential to raise your monthly mortgage payments because you're taking cash out of your home, and you need to pay off the extra amount you borrow. That could lead to a situation where you fall behind on your mortgage payments, thereby putting you at risk of losing your home.

Time your cash-out refinance strategically

It's a good idea to look at a cash-out refinance when borrowing rates are generally favorable. And it's also a good idea to pursue a cash-out refinance when your credit score is in good shape, since that makes it more likely that you'll end up with a competitive rate on your loan (or at least competitive in the context of where borrowing rates are at the time).

But just as it's important to get your timing right with a cash-out refinance, it's equally important to crunch the numbers before you sign one so you're sure you can handle your new monthly loan payments. The last thing you want to do is borrow too much and put yourself at risk of foreclosure.