The Pros and Cons of Cash-Out Refinance

A family weighs the pros and cons of a cash-out refinance of their mortgage to fund a home renovation.

Key takeaways

  • A cash-out refinance is a lending structure that allows you to replace your mortgage with new terms, and receive a portion of the new loan as cash proceeds after closing.

  • A cash-out refinance can be a more favorable option than high-interest credit card debt or payday loans.

  • Like all debt, cash-out refinancing comes with considerable risks, including paying more in the long term and delaying other financial goals (such as retirement).

  • A home equity agreement (HEA) is an alternative to a cash-out refinance that gives homeowners liquidity from their equity without the burden of a new loan.

Rising inflation may mean that you have a greater need for cash to meet the demands of rising costs. You might have heard mention of a cash-out refinance of your mortgage as a method for accessing equity from your home for short-term cash demands. Before calling your lender, consider the pros and cons of a cash-out refinance to see how it aligns with your financial goals compared to other options.

The basics of refinancing

Refinancing is the process of modifying the existing financing for your home (your mortgage) for the general purpose of receiving more favorable lending terms.

A mortgage refinance can take place with your current lender, or with another new mortgage company. The process is very similar to applying for a mortgage, and usually involves completing an application, reviewing your credit score and determining your qualifying terms.

One or more of the key terms of your mortgage will likely change with a refinance, which in turn, will alter your monthly payment:

  • Principal sum: The amount of your loan could either increase or decrease with a refinance. For example, placing a larger down payment could decrease the borrowed amount. Alternatively, a cash-out refinance (explained below) could mean increasing the principal sum.

  • Interest rate: Your refinancing could also raise or lower the qualifying interest rate for your loan. Furthermore, you could switch from a variable (adjustable) interest rate to a fixed rate, or vice versa.

  • Term length: A refinance could mean changing the repayment horizon for your mortgage. In most cases, mortgage terms are 15 or 30 years.

Reports show that the value of mortgage refinance originations reached levels not seen since 2003.

When do people refinance their mortgage?

The timing for considering a mortgage refinancing will vary from person to person, but usually happens when one or more conditions arise that create a refinancing opportunity. These conditions can be external or internal, and could include:

  • Significant changes in market interest rates compared to your current rate

  • An increase in the value of your home

  • Changes in your credit score that may qualify you to borrow more or obtain a lower rate

What is a cash-out refinance?

A cash-out refinance is a particular type of refinancing where you opt to borrow a larger principal sum and receive a portion of that sum as cash proceeds (i.e., the cash-out) during closing. Borrowers typically consider a cash-out refinance when they have equity in their home but lack liquidity to meet other financial goals or obligations.

The ability to borrow more may result from having made considerable principal contributions to your current mortgage, or from the increased value in your home due to market conditions. Ultimately, the amount you can borrow and receive as the cash-out portion will likely depend on your loan-to-value (LTV) ratio and credit score.

How does cash-out refinancing compare with a HELOC or other home equity loan?

A cash-out refinance is similar to other house-based lending options, such as a home equity line of credit (HELOC) or home equity loan (HEL) in that the borrower leverages the value of their home in exchange for more cash, which they can use to pay off debt, or to make home improvements or large life purchases.

The key difference between a cash-out refinance and other home equity loans is the overall structure in place. A refinance involves replacing an existing mortgage with a new mortgage under different terms. The other home equity-based loan options generally involve carrying one or more loans (the HEL or HELOC in addition to the primary mortgage). The two loans can have different interest rates, term lengths and other repayment terms to navigate. In comparison, a mortgage refinance has a more singular and streamlined outcome.

What are the pros and cons of cash-out refinancing?

Weighing the potential pros and cons of cash-out refinancing your mortgage requires a consideration of the prospective benefits in light of the financial risks. The degree of these pros and cons will likely shift depending on your current financial situation, and your short and long-term money goals.

The possible benefits of a cash-out refinance

The following are some of the main benefits of a cash-out mortgage refinance.

Access your home’s liquidity to reach other financial goals

The reason many people consider a cash-out refinance is the benefit of receiving a lump-sum payment after closing that they can use to reach financial goals. Borrowers looking to benefit from a cash-out refinance could use the funds for any number of purposes:

  • Paying off high-interest debts such as credit card, medical, student loan or vehicle loan debt

  • Paying for home improvement projects

  • Funding other large expenses, such as buying a car or paying for a child’s school tuition

  • Funding a business venture or other investment opportunity

However, a cash-out refinance requires a solid plan and discipline to ensure you use the funds as intended.

Cash-out refinancing may be preferable to other high-interest loans

Compared to other loan options, a cash-out refinance may offer more favorable terms when it comes to the interest rate and other repayment terms. Current mortgage refinance rates are approaching 6% and they're still expected to rise. However, credit cards or short-term payday loans will likely come with interest rates of 13-30%.

Other financing options may also have a shorter maturity date, which creates risk if you were unable to make a timely repayment of the loan. The consequences of the default could be collection proceedings, foreclosure on any collateral and harm to your credit profile. A cash-out refinance, in contrast, will have a repayment term that aligns with the terms of the mortgage, which means your short-term cash flow won’t feel the stress of a looming balloon payment.

The potential downsides to a cash-out refinance

The upside of a cash-out refinance compared to other loans may be hard to ignore if you have liquidity needs. However, no financial transaction is without risk, and a cash-out refinance is no exception.

Payment of closing costs to procure the new loan

Closing on a mortgage refinance will require the payment of fees and other costs to process the loan. These costs generally include payment for the following:

  • Mortgage broker fees (fees paid to a third party for procuring the mortgage)

  • Loan application fee

  • Fees to obtain credit reports

  • Title search and title insurance fees

  • Loan origination and underwriting fees

  • Home appraisal fees

Data from 2021 shows that closing costs for home financing and purchases increased by more than 10%.

Depending on the lender (and your preference), you will either pay the closing costs for your refinance upfront, or the lender will roll the closing costs into the overall value of your loan. In either case, closing costs will cut into the overall benefit you receive as an added expense to the transaction. If your closing costs are rolled into the loan, you will, in the long term, pay more for those closing costs because of the interest that will accrue over the term of the loan.

Extending the repayment of your house

In addition to the expense of closing costs, it’s important to remember that a cash-out mortgage refinance means you are signing up for a new loan. That translates to a new maturity date that is likely further into the future than the payoff date for your current mortgage. For younger homeowners who have many income-earning years ahead of them, this may not be a major concern.

Homeowners closer to retirement, though, must consider the risk of carrying mortgage debt into retirement. Mortgage and housing costs are usually a person’s largest living expense, and may be too high for retirement benefits to cover. Homeowners should carefully consider how a cash-out refinance (and the underlying reason for the cash-out) aligns with their retirement planning goals.

Here's an explanation of a cash-out refinance’s potential drawbacks, such as higher interest rates and higher closing costs.

Adding more secured debt to your balance sheet

Even though a cash-out refinance may provide certain advantages over credit card debt and other loan options, it is still debt. No matter the structure, the nature of debt means receiving an immediate benefit upfront (cash in this case) while having to pay more for the value of that item over the long term.

Responsible uses of a cash-out refinance, such as debt payoff, can mean saving more money over time. However, borrowers may want to consider all options for their financing, beyond ones that add to debt. Solutions may include downsizing your home, selling assets or finding ways to reduce expenses that open up cash flow.

A cash-out refinance will only give you a fixed amount

Another important consideration for a cash-out refinance is the fact that you will receive a fixed amount, which means understanding how that corresponds to its intended use. Take the time to calculate, if possible, the amount of money you would need from the refinance to reach your other financial goals.

If you’re unsure of the amount of money that you’ll need from the cash-out refinance, then other loan types may be more suitable. This may be the case for a home renovation project, especially if relying on labor and cost projections from a contractor. In the case of unknown cash needs, a HELOC may be a better fit because it allows you to withdraw funds on an as-needed basis.

Downturns in the real estate market

Finally, you should also consider the risk that a change in the real estate market could bring to the overall benefit of a cash-out refinance. A cash-out refinance relies on the equity of your home to provide liquidity at closing. Usually, this equity comes from your payment towards the principal of the current mortgage in addition to inflation. Either way, this is unrealized equity that can change with the sentiment of the market.

In theory, market changes are not a concern in the short term unless you must sell your home. If you had to sell after a cash-out refinance, it creates the potential for a situation where you owe more on the loan than you could acquire through its sale.

Home equity agreement as an alternative to cash-out refinancing

A home equity agreement (HEA) might be an appealing alternative for homeowners interested in accessing their home’s equity, but who don’t want to take on added debt. With a HEA, you sell a percentage of your home’s future value. In exchange, you receive cash proceeds up front that you can use to fund home improvements, pay off debt or manage other financial affairs.

Some general eligibility requirements include:

  • Your property must be residential (i.e., non-commercial)

  • A minimum FICO score of 500

  • An 80% LTV ratio

The benefit of using a HEA is that you won’t have a traditional monthly mortgage payment that accrues interest. This can greatly improve your cash flow and add flexibility.

How long do you have to repay the amount you owe under HEA?

Standard HEAs usually have 10-year terms. This provides homeowners with some flexibility for repaying the provider within that period. One option is to sell the home. Another is to buy out the equity interest in advance. The process for a buyout generally requires an independent appraisal to evaluate the home’s fair market value and determine the amount owed under the agreement.

Interested in a home equity agreement?

Understanding the pros and cons of a cash-out mortgage refinance, HEA or other arrangement is key to making an informed decision. Carefully read and understand all terms of your agreement and seek professional help when you have questions.

Contact Unlock Technologies today to see how a HEA compares to a cash-out refinance.

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