3 Risks of a Cash-Out Refinance Loan

Don't take a cash-out refinance loan until you read this.

A cash-out refinance loan is a way to tap into the equity of your home while also modifying the terms of your current mortgage loan. It works simply. You apply for a new mortgage loan for more money than you currently owe. If you qualify based on your financial credentials and the value of your home, the lender offering the cash-out refi will repay your current home loan and give you some cash back.

Cash-out refinance loans can give you money you need to repay debt, remodel your home, or fund big purchases. But there are risks associated with taking on this kind of debt. Here are three of them.

1. You could end up making your total mortgage repayment costs higher

A cash-out refinance loan changes the terms of your current mortgage loan. This could include both the interest rate and the repayment timeline.

If you raise the interest rate on your current loan, you would make your mortgage more expensive over time since you'd pay a higher borrowing cost. But you could also end up paying higher borrowing costs even if you lowered the rate, if you made the payoff time much longer.

For example, if you had 10 years left to pay your current loan but you took a cash-out refinance loan into a new 30-year mortgage, adding 20 more years of interest expenses would inevitably raise borrowing costs even if you dropped your rate.

2. You may increase the risk of foreclosure

When you take out a cash-out refinance loan, you're raising the size of your loan balance because you're borrowing more than you owed before. In many cases, this means your monthly payment will become more expensive even if you drop your interest rate and keep your repayment time similar.

If your loan costs more to pay each month, it could be harder to pay it during times of financial hardship so foreclosure may be more likely to occur as a result. Losing your home to foreclosure can be financially devastating.

3. You could end up owing more than your home is worth

Taking a cash-out refinance loan reduces the equity in your home since your loan balance will now be larger relative to the house's value as a result of borrowing extra cash. This increases the chances your home's value will fall below what you owe on it.

If this occurs, you're said to be underwater on your mortgage loan.

Being underwater means selling your home gets harder. The proceeds from the sale wouldn't be enough to fully repay your loan if you got paid the market value for the property. You'd have to come up with the difference to pay back your lender or try to arrange a short sale where the lender accepts less than the full payment. You also couldn't refinance again or take a home equity loan if you needed to if you were underwater, so lenders won't loan you more than your house is worth.

These are serious risks to consider, so before you choose a cash-out refinance loan, be certain you're comfortable with the potential downsides. When you're putting your home on the line, you have to be 100% certain you're making the right financial move.