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There's a reason refinancing has been hot in 2020. With mortgage rates at record lows, it's been a great time for homeowners to lower their monthly payments and enjoy long-term savings.
But not all refinances are created equal. There's the standard refinance, when you borrow enough to cover your remaining mortgage balance, and there's the cash-out refinance, when you borrow more than your outstanding balance and use the excess for whatever you want.
Interestingly enough, borrowers have been judicious about the latter. Cash-out refinances comprised just 27% of all mortgage refinances in 2020's third quarter, according to Black Knight, a mortgage data provider. That's the lowest share in seven years.
Furthermore, those opting for cash-out refinances are taking out less cash than borrowers did in the past. The average amount of equity taken out of a home via a cash-out refinance dropped from $63,000 in 2020's second quarter to $51,600 in the third quarter. And that could be a sign that Americans are making an effort to borrow more responsibly.
The dangers of a cash-out refinance
A cash-out refinance can be a good solution when you have a sudden need for money, or if you're carrying costly debt and want to pay it off affordably. Imagine you owe $20,000 on a credit card charging 18% interest. If you snag a mortgage refinance at 3% and pay that $20,000 with cash you take out of your home equity, you effectively lower the interest rate on your credit card balance by 15%.
The problem with cash-out refinances, however, is that they're easy to abuse. Generally, you qualify for one as long as there's equity in your home -- meaning your home is worth enough that a lender will loan you that cash as well as your remaining mortgage balance. But that could open the door to careless spending. Since you're not restricted in how you use that extra cash, you could take out $20,000 to go on a luxury vacation, or buy a sports car you don't need.
Even more frightening is the fact that if you fall behind on your mortgage payments after a cash-out refinance, you could eventually risk losing your home to foreclosure. A cash-out refinance can make your monthly mortgage payments higher, even if you manage to lower the interest rate on your home loan. That's because you're actually borrowing more than your current home loan. But if you fail to keep up with the payments, your lender could eventually force the sale of your home to get repaid. By contrast, if you fall behind on your credit card minimums, you can damage your credit score -- but your credit card company can't go after your house.
While cash-out refinances can work out well in some situations, they also put borrowers at risk. If you're going this route, make sure you know exactly what you're getting into. And make sure you're taking that cash out for the right reasons.
