3 Cash-Out Refinance Pitfalls You Should Know About

Thinking of doing a cash-out refinance? Consider the drawbacks involved.

If you have a lot of equity in your home -- meaning, you own a substantial portion of your home outright -- then you may be considering a cash-out refinance. With a traditional refinance, you swap your existing mortgage for a new one and borrow the same amount you owe on your original loan. With a cash-out refinance, you borrow more than your remaining mortgage balance, and you can use the rest for any purpose, from paying off high-interest credit card debt to paying for education.

In many cases, it pays to do a cash-out refinance, especially when refinance rates are attractive. But be careful, because a cash-out refinance could lead to these dangerous traps.

1. Supporting frivolous spending

Cash-out refinances are extremely flexible. The money you receive from one can be used for anything you want -- but that's not necessarily a good thing. If you owe money on a credit card that's charging you 20% interest or a personal loan charging you 8% interest, and you're eligible for a 3.5% interest rate on a cash-out refinance, then it pays to go that route. You can use the extra money you get from your mortgage to consolidate that debt and pay it off at a much lower interest rate.

On the other hand, you could just as easily use the money you get from a cash-out refinance to go on a luxury vacation. And that's the sort of thing you shouldn't do unless you've saved for it. In fact, a cash-out refinance could cause you to engage in spending that's too carefree for your own good.

2. Raising your foreclosure risk

When you do a cash-out refinance, you take out a larger home loan. And the larger that loan, the higher your monthly mortgage payment. That increases the risk of you falling behind on it and losing your home in the process.

Of course, doing a cash-out refinance doesn't automatically mean you'll fall behind, and your monthly payments may not rise all that much if you don't take too much cash out of your home. You may even be able to score a much lower interest rate on your loan than what you were previously paying. But it is a concern that should be on your radar.

3. Racking up expensive closing costs

When you refinance a mortgage, you're required to pay closing costs that are calculated as a percentage of the amount you borrow. The higher your loan amount, the more money you'll spend to finalize your new home loan.

Closing costs vary by lender, but they usually amount to 2% to 5% of your loan amount. If you owe $100,000 on your mortgage but do a cash-out refinance for $120,000, you could end up paying 5% closing costs on that extra $20,000. This equals $1,000 in closing costs for that portion of your new mortgage alone.

There are plenty of situations where a cash-out refinance makes sense. But if you're thinking of doing one, make sure you truly understand the risks and drawbacks involved.