Cash Out Refinance: What Is It and How Does It Work?

Mortgage

There may come a time when you need to access a large amount of cash to pay off credit card debt or fund a home improvements. And when that happens, you can consider using one of the greatest assets at your disposal — the equity in your home.

couple on laptop

A cash-out refinance is a mortgage refinancing option that allows you to renegotiate the terms of your mortgage and turn your home equity into cash. This article will explain what a cash-out refinance is, the pros and cons, and how to determine whether it’s right for you.

What is a cash-out refinance?

A cash-out refinance is a way to access some of the home equity you’ve built up. You’ll refinance your existing mortgage at a higher amount, and then you get to keep the difference.

For example, let’s say you own a $250,000 home and still owe $200,000. If you want $20,000 in cash, you’ll do a cash-out refinance for $220,000. $200,000 will go towards your mortgage, and you’ll receive a cash payment of $20,000.

A cash-out refinance is different than simply refinancing your home. When you refinance, you take out a new loan for the same amount but at a lower interest rate.

Similar to a home equity loan, the goal of cash-out refinancing is to lower your interest rate. With a cash-out refinance, you’re turning the home equity into cash. Cash-out refinancing is usually less expensive than a home equity loan.

What are the pros and cons of a cash-out refinance?

There are advantages and disadvantages to any financial decision, and this is certainly true for a cash-out refinance. Understanding some of the pros and cons can help you decide whether this is the right move for you.

Pro

  • Consolidate debt: The average interest rate on credit cards is 17.25%. But if you’re carrying a balance from month to month, this can add up to a lot of money in interest. Using a cash-out refinance to pay down credit cards can save you thousands of dollars.
  • Fund home improvement projects: Home improvement projects are usually a good investment because they increase the value of your home. However, not all projects will add the same amount of value, so make sure you do your homework first.
  • Boost your credit score: If you use the money to pay off debt, this will lower your credit utilization. This impacts your credit score by up to 30%, so reducing this can improve your score.
  • Improve the terms of your home loan: When you refinance your home, you’re replacing your current mortgage with a new one. This could mean shorter payment terms, and you may be able to qualify for lower interest rates.
  • Possible tax deduction: If you use the money to improve your home, then you may be able to take advantage of the mortgage interest deduction. You should consult with a tax professional to find out if you qualify for the deduction.

Cons

  • Private mortgage insurance (PMI): If the value of your home falls below 80%, you’ll have to pay PMI. PMI costs between 0.5% to 1.0% of the total loan amount. So you need to be sure the benefits you stand to gain outweigh these costs.
  • You’ll have new mortgage terms: In some situations, taking out a new loan with new terms could be an advantage to you. But if you already have a very low interest rate, this could work against you. Make sure you understand the terms and conditions before agreeing to anything.
  • Closing costs: When you refinance your home, you have to pay closing costs, which are the fees paid to finalize a real estate transaction. These costs are usually between 2% and 5% of the loan amount, so this will be thousands of dollars you’ll have to pay out of pocket.
  • Won’t fix bad financial habits: Using a cash-out refinance to pay down debt can be a smart decision. But it won’t help you if you rack that debt back up again. Make sure you work on improving your financial habits, so you don’t stay stuck in a cycle of debt.
  • You put your home at risk: With a cash-out refinance, your home is used as collateral to guarantee the mortgage loan. So if you’re unable to make the payments, you are in danger of losing your home.

How can you use a cash-out refinance?

The money you receive from a cash-out refinance can be used for pretty much any purpose. You can use it to pay down high-interest credit card debt or for home renovations.

However, just because you can use this money for any expense doesn’t mean you should. Paying down high-interest debt is a good move because it’ll reduce the amount you pay in interest. And home improvements can help you increase the value of your home.

But it’s not a good idea to use a cash-out refinance to fund things like vacations or brand-new cars. The return on your investment will be minimal, and you’ll be putting your home at risk for very little reward.

Alternatives to a Cash-Out Refinance

A cash-out refinance won’t be the right choice for everyone. If you need to access a large amount of cash but aren’t sure about a cash-out refinance, there are alternatives you can consider.

  • HELOC: One of the most popular alternatives to a cash-out refinance is taking out a home equity line of credit (HELOC). A HELOC is kind of like a personal loan and a credit card all rolled into one. It’s a revolving line of credit and is less expensive and less time-consuming than a cash-out refinance. Plus, you’ll only pay interest on the money you actually borrow.
  • Personal loan: If you want access to a large, lump sum of money, personal loans could be a good alternative. These loans are faster to process than a cash-out refinance, and you’ll pay off the money in a much shorter time period.
  • Look for other ways to find the money: And finally, you may want to consider if there are other ways you can find the money you need. Could you borrow the money from friends or family or take on a side job? This isn’t the most exciting alternative, but if you can make it work, it’ll save you from taking on more debt.

Summary

In the right circumstances, a cash-out refinance can be a good move. It can help you re-invest into your home, pay off debt, and improve your financial situation.

However, a cash-out refinance is not a quick fix. If you don’t change the behaviors that created the problem, you run the risk of just digging yourself into an even deeper financial home. Plus, you’re putting your home at risk in the process.

If you choose to go forward with a cash-out refinance, be sure to put your money to good use. Use this experience to put you and your family in a better position financially.

Jamie Johnson
Meet the author

Jamie Johnson is a freelance writer who has been featured in publications like InvestorPlace and GOBankingRates. She writes about a variety of personal finance topics including student loans, credit cards, investing, building credit, and more.