3 Bad Reasons to Do a Cash-Out Refinance

If you're going to take money out of your home, make sure it's for the right purpose.

Mortgage refinance rates are very low these days, so a lot of borrowers are getting new home loans to take advantage of them. Now, when it comes to refinancing, you have choices. You could do a standard refinance where you borrow your exact mortgage amount, or you could do a cash-out refinance where you borrow more than what you owe on your home and then use the extra money for whatever purpose you'd like.

In some situations, a cash-out refinance can be a smart move. But here are three bad reasons to get one.

1. To take a vacation

After the year we've all had grappling with the pandemic, we could all use a getaway -- maybe even an extended one. But borrowing money to take a vacation isn't usually a financially sound move.

Remember, a cash-out refinance is still a loan. When you do one, you wind up with a larger mortgage balance than what you started with, and while you may manage to snag an affordable interest rate on your new mortgage, it's debt nonetheless. A better bet is to take a low-key vacation now if that's all you can swing, and then work on saving up enough money to take a longer, more extravagant one down the line.

2. To maintain a lifestyle you can't afford

If you've been falling behind on your bills for quite some time, you may be tempted to do a cash-out refinance. That way, you could use the extra money to supplement your income and keep up with your bills.

But actually, that's not a great idea. If you consistently can't cover your living expenses, it means you're spending too much. And if so, your best bet is to set up a budget so you can track your spending and start cutting back in areas where you have the most wiggle room.

3. To pay off a very small credit card balance

If you have a large amount of credit card debt in your name, then a cash-out refinance could be a good way to pay it off. Imagine you owe money on a credit card charging 22% interest, and you can refinance your mortgage at 3.2%. If you take the proceeds from your cash-out refinance and use that money to pay off your credit card debt, you'll save yourself a lot of money on interest, so doing that makes sense when your credit card balance is substantial.

But if you only owe, say, a few hundred dollars on a credit card, then a cash-out refinance may not be as cost-effective as you'd think. That's because you'll pay closing costs on the amount you borrow that could easily end up equaling 5% of your loan. If your credit card debt is minimal, you may be better off seeking out a balance transfer credit card offer instead.

A cash-out refinance could help you consolidate large debt, make improvements to your home, or pay for expensive repairs you've been putting off. But don't do a cash-out refinance if your goal is to spend money on something you can't afford, maintain a lifestyle you can't really swing, or pay off a minimal amount of debt. There are better ways to address those issues, and if you do a cash-out refinance in any of those situations, you might end up regretting it.