As a homeowner with lots of expenses, you’ve probably thought about using your house as collateral for a loan. In fact, if your credit is good and you have equity in your home, lenders are probably lining up to sell you a new loan that will give you cash back. Before you agree to a cash out refinance, it’s essential to understand how this type of loan works and weigh its pros and cons.
What Is Cash Out Refinancing?
With a cash out refinance, a new, larger loan pays off your existing mortgage, and the difference goes back to you in cash.
For example, if you owe $200,000 on your mortgage and your home appraises for $300,000, you might qualify for a new loan amount of $240,000. You could use the $40,000 to pay off other debts, make improvements to your home, or take care of other financial needs.
Pros of a Cash Out Refinance
Here are some of the advantages of choosing a cash out refinance. See if any apply to your current situation.
Lower Interest Rates
In most cases, you’ll get a lower interest rate when refinancing than you would if you took out a home equity loan. The lower rate can sometimes allow you to finance a larger amount without increasing your monthly payment.
Since your mortgage interest is tax-deductible, you will be able to write off the interest, even with the new, larger loan.
Ability To Increase Home Value
Using your equity for a home renovation can sometimes increase the value of your home. Depending on the improvement, it can quickly help you rebuild the used equity.
Using your loan to consolidate debt can immediately lower your monthly expenses, increasing your cash flow.
Cons of a Cash Out Refinance
Consider the following disadvantages if you were to choose a cash out refinance.
Enabling Bad Habits
If you’re not financially disciplined, there’s a temptation to spend your home’s equity on something foolish or get right back into debt.
Under normal circumstances, when times get hard, you can prioritize your house payment over other bills. However, if you consolidate your debt into one colossal mortgage payment, you’ll be more at risk for foreclosure. A balance transfer to a low-interest credit card is another way to reduce monthly expenses without putting your house on the line.
Refinancing is never free. Either you’ll need to bring money to the table for closing costs, or the finance company will roll those costs into the loan.
Higher Loan Balance
Even if your new mortgage payment is lower, you’ll owe more on your home in total after refinancing.
Private Mortgage Insurance
If you end up financing more than 80% of your home’s value, you’ll have to pay for private mortgage insurance, or PMI, which is yet another cost to consider.
Avoid attaching more debt to your home by taking out an unsecured personal loan instead of refinancing. Many banks, credit unions, and online lenders offer this kind of loan to borrowers with excellent credit.
If you’re doing a cash out refinance, be sure you’re getting a reasonable interest rate and have a plan for using the money wisely. Pulling out some of your home’s equity may be the perfect solution for you right now, but you won’t want to make a habit of it.