If you’re considering a cash-out refinance on your home, there are some important things you need to know so you fully understand what you’re signing up for. Let’s go over what exactly a cash-out refinance is (and how it’s different from a HELOC), along with the pros and cons of a cash-out refinance.
What is a cash-out refinance?
A cash-out refinance lets you accomplish two things:
- Refinancing your mortgage (replacing your existing mortgage with a new one, often from a different lender).
- Trading some of your existing home equity for cash you can use immediately. The amount of your equity cash-out is added onto your new mortgage to be repaid over time.
Essentially, when you opt for a cash-out refinance, you are giving yourself a bigger mortgage (which could mean it’s longer or has higher monthly payments) in exchange for the quick cash.
Think of it as if you're undoing some of your past mortgage payments. You get the money back in your wallet, but also sacrifice equity and take a step back in your overall mortgage repayment progress.
As an example, let's say your home is worth $250,000, and you still owe $100,000 on the principal mortgage balance (so you have 60% equity). With a cash-out refinance, you could cash out 20% of your home equity to get $50,000 in cash, changing the mortgage amount you owe to $150,000 and dropping your home equity to 40%. (Note that many lenders won't let you drop below 20% equity in a cash-out refinance.)
Different types of cash-out refinancing
While specific terms of any refinance will depend on the lenders you're working with, there are two main types of cash-out refinancing:
- Standard cash-out refinance. This is the most common type. It allows you to use your cashed-out funds for any reason.
- Limited cash-out refinance. This type is much more restrictive of how much you can withdraw and what the money can be used for. Usually, these are used to roll the actual costs of refinancing into the new mortgage, such as closing costs, so you don't have to pay them out of pocket. If you end up with any actual cash in hand, it won't be more than $2,000. The perk is that you aren't giving up equity with a limited cash-out refinance.
How is a cash-out refinance different from a HELOC?
A home equity line of credit, or HELOC, is a loan that uses your home’s equity as collateral to guarantee repayment. You borrow what you need and make payments on the HELOC loan. If you miss payments on the HELOC, you risk losing your home, just like you would if you missed mortgage payments.
One key difference is that HELOC is not a type of mortgage itself and does not affect your existing mortgage—it's a totally separate line of credit that you can draw on as needed, like a credit card. By contrast, a cash-out refinance replaces your existing mortgage and increases the loan amount.
If you have a mortgage and a HELOC, you’ll need to make payments to both of them since they're separate loans. With a cash-out refinance, it’s all combined into one new mortgage loan.
The associated costs differ as well. When you refinance your home (whether it's a cash-out refinance or a regular one), you have to pay new closing costs just like when you originally bought your home. Refinancing costs can amount to 2-5% of your mortgage principal when you factor in appraisals, inspections, early repayment fees, and more.
Fees involved in a HELOC also vary but can include application, appraisal, title search, lawyer costs, annual membership fees, inactivity fees, and others.
Finally, while there can be other reasons and benefits involved in home refinancing (which I'll touch on below), the only thing a HELOC does is make cash available to you. However, that can be beneficial if you only need a small amount that doesn't justify a whole refinance (and you're unable to get the funds another way).
What are the pros of a cash-out refinance?
The main reason to do a cash-out refinance is that you get immediate liquid cash that you could use for important things like high-interest debt payoff, necessary home repairs, etc.
Like with any mortgage refinance, the other benefit is that you might be able to negotiate more favorable loan terms. Specifically, you'll want to shoot for a lower interest rate on the mortgage loan. Ideally, the interest you save over the life of the loan should outweigh the refinancing costs, so you're coming out ahead in the end.
People also often refinance in order to reduce their mortgage payments or shorten their loan term. However, it's unlikely you can do either of these with a cash-out refinance, since you're adding to your loan.
What are the cons of a cash-out refinance?
I've already touched on some of the disadvantages, but they're worth thinking about long and hard before diving into this type of refi.
The first, of course, is that since you’re giving up equity and adding extra to your mortgage loan, you’re extending how long it will take to pay off your house. You may also have a higher monthly mortgage payment than you're used to, which cuts into the amount of money you're able to save or invest.
Next, even if you refinance for a lower annual interest rate, you’ll likely pay more total interest over the life of the loan. This is because the payments will probably be larger and the term longer, which means more time for interest to add up.
As we've already covered, you pay various closing costs when you refinance a mortgage that can amount to thousands of dollars. You might pay this out of pocket or use some of your cash-out amount to cover it. Either way, it's another expense that may not be necessary.
When should you consider a cash-out refinance?
Unless you’re in a very dire position, you should be extremely cautious about choosing a cash-out refinance. Maybe you need money for a home repair that really can’t wait, or you have a medical emergency that can’t be negotiated, or you’re drowning in credit card debt and would rather have extra mortgage debt at a lower rate instead of the high interest on credit card debt.
Those could all be valid reasons, but make sure to explore all your other options before choosing a cash-out refinance.
Think about how long it took you to earn the equity you have in your home. You don’t want to give that up for a reason you don’t really need, like a new patio or swimming pool.
Before getting one, also carefully consider how it will affect your short-term and long-term plans. Would a higher monthly mortgage payment fit into your budget? Will having a longer mortgage term make it difficult to pay off your house by the year you want (e.g. retirement)?
Crunch all the numbers and make a solid plan that considers both your current circumstances and your future.
Other options to get the cash you need
Since it’s best to save options like a cash-out refinance for a last resort, how else could you get the money you need? If it's something that can wait, your best option is to hold out and save up as much as you can. But if you're in an emergency, that might be less viable.
There may not be a perfect quick-fix solution, but visit our articles on increasing your income, getting through financial hardship, starting a successful side hustle, and earning money quickly. If you still need to consider a cash-out refinance, you can be confident that you did the best you could in trying other ideas first.