If you own a home and need money, one of the first thoughts that might shoot into your head is: Can I use the equity in my house as collateral for a loan?
There are many ways to use the equity in your home to your advantage. One is through cash out refinancing. Whether or not it’s the best option for you depends on a lot of factors, which we will cover below.
What Is Cash Out Refinancing?
Cash out refinancing is when you take out a loan worth more than your original mortgage. You use the loan to repay the original mortgage and the remaining cash is yours to do with as you please. You can borrow up to 80% of your home’s equity.
If that sounds confusing, hang in there. We’ll explain.
Let’s say you took out a $200,000 mortgage to pay for your home 10 years ago. You now owe $100,000 on the house. You decide you want to install a new patio and, while you’re at it, a driveway.
To pay for all this, you will take out a cash out refinancing loan worth $180,000. The first $100,000 will cover the remaining mortgage balance. The $80,000 leftover is yours to pocket and use for whatever you want, including a new patio and driveway
Traditional refinancing, in contrast, would only cover the amount owed on the house.
Keeping with our example, you would refinance the $100,000 mortgage for better terms like a lower interest rate, but there would be no balance leftover to keep.
Cash Out Refinancing Pros and Cons
In one corner, you have potentially lower interest rates. In the other corner, you have the potential risk of foreclosure and loss of your home.
Let’s take a deeper look at the benefits and drawbacks of a cash out refinance, so you can decide if it’s the wisest move for you.
Benefits of Cash Out Refinancing
Lower Interest Rates
Your interest rate will only be lower if you bought your home at a time when rates were high. This is not always the case.
As of November 2019, the average 30-year fixed mortgage rate is 3.83%. A cash out refinance would yield you a better rate, if you bought your home in 2008 when the 30-year fixed was 6.03%.
If you bought your home in 2012, when the average rate was 3.66%, a cash out refinance will not magically gift you an even lower rate. Instead, you would lose money on the exchange.
A cash out refinance can consolidate debt that has gotten out of control. Whether it’s a host of maxed out credit cards, or a high-interest payday loan you unwittingly decided to roll the dice on, a cash out refinance can help you wedge yourself out of a tight corner.
Potential Impact on Credit Score
If you use the money to repay credit card debt, your credit score could soar.
Credit scoring models use something called “credit utilization” to calculate your credit score. It’s a ratio of your credit limit versus how much you owe, and it accounts for 30% of your credit score. Even if you’re making on time payments every month, your score will suffer if you use too much of your credit limit. It’s recommended to keep your utilization ratio under 30%.
Lowering your credit utilization ratio always looks good to the credit bureaus and could lead to even lower borrowing rates down the line.
Mortgage debt is tax deductible. This means you can write off the interest of your cash out refinance loan. But there’s a catch. You can only deduct the interest from a cash out refinance loan if you used that loan to pay for home improvements that increase the home’s value, i.e. upgrading to granite countertops or installing a new patio. You cannot deduct interest if you used the money to consolidate debt, send your kid to school, or pay for a vacation.
Drawbacks of Cash Out Refinance
Risk of Foreclosure
If you miss enough payments, you risk losing the house. A cash out refinance should not be approached with the same nonchalance as opening a Macy’s credit card. It’s a serious investment, with serious, long-term implications should things go south. Every three months, 250,000 new families enter into foreclosure, according to the Federal Deposit Insurance Corporation (FDIC).
Keep this in mind if you plan to use the cash out refinance loan (or secured debt) to consolidate unsecured debt like credit cards. Without the proper budgeting and foresight, you could end up making a bad situation even worse.
New Loan Terms and Costs
A cash out refinance, like any other refinance, will come with a host of fees and closing costs to consider. Make sure the numbers add up in your favor before you pull the trigger.
Closing costs will run you 2-5% of the new loan amount. A loan of $180,000 would cost you between $3,600-$9,000.
Shop around and don’t settle for the first offer. Remember, If the new loan exceeds 80% of the home’s value, you will need to pay for private mortgage insurance, which will run you between 0.55%-2.25% of the loan. That’s as much as $4,050 a year.
Short Term Solution
Your home is your most precious asset; it should not be the first thing you look to leverage when you’re in a financial pickle. It should only be used with a clear, thought out goal in mind.
You have to ask yourself if a cash out refinance is more than just a short-term solution to an overarching problem. If you’re having trouble reaching a conclusion on your own, it can help to speak with a nonprofit credit counselor trained to assess these situations and provide debt relief.
Cash Out Refinance Alternatives
A cash out refinance isn’t the only way to dip into your home’s equity. Here are a few alternatives that may prove wiser depending on your situation.
HELOC vs Cash Out Refinance
A home equity line of credit (HELOC) is similar to a cash out refinance. Both tap into the equity of your home, and both prop up your home as collateral. However, there are some key differences.
HELOC’S provide you with a line of credit. This means you can pull out funds over a period of time, as opposed to taking out a lump sum. They also come with a variable APR, which could spike down the line and cost you a lot of money.
Home Equity Loan
A home equity loan, like a cash out refinance, supplies you with a lump sum of as much as 80% of your home’s equity. The difference is that a cash out refinance transforms your first mortgage into a new mortgage, whereas a home equity loan is a second mortgage, separate from the original.
We’re talking two payments (home equity) vs. one payment (cash out).
Also, cash out refinances tend to have lower interest rates, while home equity loans tend to have lower closing costs. Sometimes the lender may even absorb the closing costs of a home equity loan.
Nonprofit Credit Counseling
You’re about to make a decision that puts your money and your home on the line. Why rush into it? Gather as much information as possible and consider getting in touch with a nonprofit credit counseling agency.
Nonprofit credit counselors are experts at matching consumers with the solutions best suited for their goals.
Maybe your situation calls for debt consolidation, debt settlement, or even bankruptcy. The point is, you need to review all of your options before making a big financial decision like taking out a second mortgage or cash out refinancing your existing one.
Home equity is a valuable tool for any homeowner, which is why you should use it wisely. Otherwise, you might just dig yourself deeper into debt.