3 Mistakes to Avoid With a Cash-Out Refinance

Taking extra cash out of your mortgage? Be sure to steer clear of these pitfalls.

When you refinance a mortgage, you swap your existing home loan for a new one with terms that work better for you. Often, that means snagging a lower interest rate on your mortgage.

With a standard refinance, you get a new loan that's equal to your remaining mortgage balance. For example, if you're left with $150,000 on your existing home loan, you'd get a new $150,000 loan.

A cash-out refinance, on the other hand, lets you borrow more than your existing loan balance so you can use the rest of the money as you please. For example, you might swap a $150,000 loan for a new one that equals $180,000. In that case, the first $150,000 would go to satisfy your existing loan balance, and the remaining $30,000 would go to you to spend on pretty much anything you want.

There are plenty of scenarios where a cash-out refinance makes sense. But if you're interested in going this route, be sure to avoid these dangerous mistakes.

1. Borrowing so much you can't keep up with your new monthly payments

Many people refinance to lower their monthly mortgage payments. But if you do a cash-out refinance and add to your loan balance, you could end up doing the opposite -- increasing your monthly payments by virtue of borrowing more, even if you lower the interest rate on your loan. Before you move forward with a cash-out refinance, use a mortgage calculator to figure out what your new monthly payment will look like based on your new loan amount -- and make sure it fits into your budget.

2. Forgetting about closing costs

When you refinance a mortgage, you're required to pay closing costs. Closing costs are set by individual lenders. There's no standard amount you'll pay, but in general, you can expect those fees to equal 2% to 5% of your new loan amount. Now remember, with a cash-out refinance, you're borrowing more money than what you owe on your existing mortgage, so the higher your loan amount, the more closing costs you'll pay. You'll generally get the option to roll closing costs into your new mortgage so you don't have to come up with that money up front. But adding too much to your mortgage balance could result in some pretty hefty fees at closing.

3. Not spending your cash wisely

Taking on a higher mortgage means running the risk that you'll fall behind on those payments. And being delinquent on a mortgage could put your home at risk of foreclosure. It's one thing to do a cash-out refinance to pay off high-interest credit card debt or invest in a business you own that could generate a lot of income for your family. But it's another thing to do a cash-out refinance so you can go on a series of nice vacations. Make sure you're doing a cash-out refinance for the right reasons. It's not worth risking your home to indulge in luxuries you might enjoy, but shouldn't be spending on if you can't afford them.

Right now, mortgage refinance rates are pretty competitive (though they have crept upward in recent weeks), so you may be thinking of doing a cash-out refinance. If you're going to move forward with it, make sure you understand the risks and drawbacks involved -- and be cautious about how much you borrow. Home values have risen substantially over the past six months, so you may have the option to borrow quite a bit above your existing mortgage balance. Be careful not to go overboard so you don't wind up hurting your finances needlessly.