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As the name suggests, a cash-out refinance loan allows you to take cash out of your home. Perhaps you have a lot of equity in your house because property values have risen or you've been paying down your mortgage. A cash-out refinance is one way to access some of that money.
Cash-out refinance loans differ from home equity loans or home equity lines of credit (HELOCs). These are both additional loans that are separate from your current mortgage. With a cash-out refinance loan, you take out a new mortgage to pay off your old home loan and get cash back by borrowing more than you currently owe.
There are some benefits, especially if you can drop the interest rate on your existing mortgage. You'd be able to tap into equity at a lower rate than you'd generally get with a home equity loan or line of credit. However, a cash-out refi also comes with risk since you're stripping the equity from your home. You'll also have to pay closing costs, just as you would with a purchase mortgage. As a result, this kind of loan makes sense in some situations but not others.
In particular, these are some of the best -- and worst -- reasons to take out a cash-out refinance loan.
The best reasons for a cash-out refinance loan
Here are two good reasons you may want to use a cash-out refinance loan.
1. Financing essential home repairs
Maintaining your home in good condition is essential to preserving its value -- not to mention, it's important you and your family have a nice, safe place to live. Unfortunately, sometimes home repairs or upgrades are necessary even when you can't pay for them with your savings.
If you're doing important work on your home (not just, say, adding a luxury kitchen because you want one), it can make sense to use a cash-out refinance loan to pay for it.
You'll get an affordable interest rate and your interest will be tax-deductible (if you itemize). Plus, hopefully, the changes you're making to the property will preserve or increase its value so you won't strip too much equity from your home.
2. Reducing interest as part of a debt payoff plan
Cash-out refinance loans often allow you to borrow at a low interest rate and deduct your interest costs from your taxes (if you itemize). As such, you can save a lot if you take out this type of loan and use it to pay off high-interest debt.
Reducing the interest on your current debt could, in turn, free up money in your budget for other things. Depending on the circumstances, you may also reduce total interest costs over the repayment period. That said, there's a risk you'll owe more interest over time, even with a lower rate, since you'll stretch out your repayment plan for decades.
However you should never borrow money against your home to refinance debt unless it's part of a well-thought-out plan to become and stay debt-free. If you use the money from a cash-out refi loan to pay off other consumer debt, you'll usually transform unsecured debt to debt that's guaranteed by your house. This isn't a decision to take lightly -- and you'll want to make sure you can make your new home loan payments without getting in over your head.
You also aren't actually solving your debt problems -- even if you cut your interest rate and monthly payment costs. You're just moving your balance around. You need to be committed to spending responsibly, living within your means, and not just running up your credit cards again. That's assuming you want to use your cash-out refi to improve your finances over the long term.
The worst reasons for a cash-out refinance loan
Here are two reasons you should never use a cash-out refi loan.
1. Financing big purchases
It may be tempting to take a cash-out refinance loan to finance something big, such as a wedding or an amazing vacation. After all, mortgage rates are so low that you can borrow far more affordably with a cash-out refi than most other kinds of loans.
However, the big question is, do you really want to gamble your house just so you can have an expensive wedding, trip, or other extravagant purchase?
If something goes wrong and you need to sell after stripping equity from your home, you may find you can't sell for enough to repay your full loan balance. This could trap you in your home or lead to a short sale that damages your credit. And if you can't make your new mortgage payments, you could face foreclosure.
The bottom line is big purchases should ideally be paid for by saving up for them. But when that's not possible, consider an unsecured personal loan, even if you have to pay a higher rate. It often makes more sense than a cash-out refi that puts your home on the line.
2. Living an unaffordable lifestyle
If you continually spend more than you earn, you may be tempted to tap into the equity in your home using a cash-out refinance loan to fund your lifestyle. This is not a good idea. Ultimately, if you don't get your spending under control you'll just wind up owing a lot of money. And you're gambling with your house, which you don't want to do. If you can't afford to make the numbers work with your take-home pay, you need to take a serious look at cutting your budget or increasing your income. Raiding the equity you've built up in your home should not be an option.