3 Problems With Cash-Out Refinancing

Considering a cash-out refinance? Think about these pitfalls before you move forward.

Home values have soared across the country over the past year, and now, a lot of homeowners are sitting on more equity than they've had before. Equity is the portion of your home you own outright, and it gives you a few different options. You can borrow against it with a home equity loan, a home equity line of credit (HELOC), or a cash-out refinance.

With a cash-out refinance, you borrow more than your existing mortgage balance. The excess cash is then yours to spend.

For example, say you owe $200,000 to your mortgage lender but have enough equity in your home for a $250,000 cash-out refinance. If you go this route, the first $200,000 of your new loan will pay off your old loan, and then you'll get $50,000 to use for any purpose you please. But while a cash-out refinance may seem appealing, here are three pitfalls to consider.

1. It could raise your monthly payments

A lot of people hear about cash-out refinances and think, "Hooray, free money!" But remember, a cash-out refinance is still a loan. And if you borrow more than your existing mortgage balance, you'll also risk increasing your monthly payments, even if you manage to snag a lower interest rate on your new mortgage. Not only might those higher payments wreck your budget, but if you fall behind on them, you'll risk losing your home.

2. It'll tempt you to spend money you shouldn't

Cash-out refinances are very flexible. The excess money you get with one is cash you can use for any reason. But that's not necessarily a good thing. With a cash-out refinance, you may be tempted to borrow money to go on vacation, purchase new furniture, upgrade your electronics, or do all sorts of things you really can't afford.

If you're going to do a cash-out refinance, have a good reason for it. Say you're carrying $50,000 in debt between a credit card balance and a personal loan. In this case, a cash-out refinance makes sense because you can probably score a new mortgage at a lower interest rate than what you're paying on your existing debt. And so if you use your mortgage proceeds to knock out that debt, you'll save money over time. Similarly, doing a cash-out refinance to improve your home is a smart move, because your home renovations could add resale value to your property. But borrowing that extra money for indulgences is a mistake you might regret.

3. It'll leave you with less equity to tap

If you do a cash-out refinance now, you may not have the option to borrow against your home in the future if an emergency strikes. As such, make sure you're exercising this option wisely.

At a time when more people may be eligible for a cash-out refinance, it's important to consider the consequences involved. Remember, too, that you'll pay closing costs on the extra sum you borrow. So if you're going to do a cash-out refinance, only borrow the amount you really think you need -- don't ask for more money just for the heck of it.