5 Cash-Out Refinancing Mistakes to Avoid

Thinking of a cash-out refinance loan? Here are five mistakes to avoid when you borrow.

A cash-out refinance loan is exactly what it sounds like: a mortgage refinance loan that lets you take cash out of your home by tapping into the equity you've built up.

With mortgage rates hitting record lows, now may be an ideal time to take out a cash-out refi loan. There are benefits to borrowing more against the value of your home, including a lower interest rate than most other types of debt, the possibility of deducting the interest on your taxes, and freeing up money you've invested in an illiquid asset. But there are also pitfalls that are essential to avoid.

Here are five big mistakes to skip during the cash-out refinancing process.

1. Draining too much equity

The purpose of a cash-out refinance is to take equity out of your home, but taking too much can put you at risk.

You don't want to end up underwater on your home -- owing more than it's worth -- because you borrowed too much. Refinancing in the future or selling your house could become a challenge because your home won't appraise for enough to secure a new loan or sell for enough to pay off your old loan.

If your cash-out refi puts the amount of your loan above 80% of the value of your home, you could also find yourself responsible for paying for private mortgage insurance (PMI) to protect your lender in case of a default.

2. Not considering the costs of a cash-out refinance loan

A cash-out refinance is almost always going to increase the total costs of repaying your new mortgage -- you're making the loan larger. If your new loan is for a larger amount and has a longer repayment period, the cost increase could be substantial.

There are also up-front costs to the refinancing process. You may have to pay for a mortgage origination fee, the cost of an appraisal, the cost of a credit check, title insurance fees, and a host of other expenses that can add up to several thousand dollars.

Lenders have to disclose the costs of your refinance loan, so make sure you take these into account when deciding if tapping the equity in your home makes financial sense.

3. Applying without having your finances in good shape

When you apply for a mortgage loan, it's imperative to have your ducks in a row when it comes to your finances.

You want to make certain you have a good credit score, stable income, and a low debt-to-income ratio. These factors can help you get approved by more lenders and can make it possible to get a lower mortgage rate.

4. Failing to comparison shop among lenders

Consumers today have more options for where to get a mortgage loan than ever before, thanks to an abundance of new online lenders.

Although you can still get a loan from traditional banks or credit unions, it's worth doing your due diligence to get quotes from multiple mortgage providers to make sure you get the best deal on your refinance loan.

Many lenders offer secure pre-approval online quickly, easily, and without affecting your credit, so it's easier than ever to find out which loan is the best deal.

5. Making unwise choices in spending the cash

There are times when it makes sense to cash out the equity in your home. If you need to pay down high-interest debt, for example, a cash-out refi is an affordable loan that could enable you to do that. Refinancing and taking out cash for home improvements can also make sense because of the low interest rates and the tax deductibility of mortgage interest on loans up to $750,000.

However, remember that you are putting your home at risk when you take out a mortgage -- and a cash-out refi means borrowing more against your house, thus increasing that risk. You don't want to find yourself facing foreclosure because you borrowed for something you didn't really need or couldn't really afford.

Likewise, if you are using the money to repay credit card or other high-interest debt, it's imperative you don't end up charging up your cards again and getting even deeper in the hole.

Is a cash-out refinance loan right for you?

If you qualify for a cash-out refinance loan at an affordable interest rate, if you won't drain your equity, and if you have smart plans for the money, a cash-out refinance loan is a great option.

And because mortgage rates are at record lows, many borrowers can get a great rate and potentially take cash out of their homes without increasing monthly payments or total repayment cost by much. Just be sure you're financially ready, can repay your loan without issue, and won't make your financial situation worse in the long run.