Prudent Advice When Considering a Cash Out Refinance Loan

When you decide to refinance your first mortgage and get cash out, you are replacing your old mortgage with a new one, with a higher balance and usually, a lower rate. This is commonly called a 'cash out refi' in the industry. You will need to have at least 20% equity in your property to be eligible.

How Cash Out Loans Works

Say you bought your house five years ago and have made the mortgage payments on time every month. While you have been paying, you now owe $80,000 on a home that is worth $250,000. The value of the home rose in this time.

You look up current mortgage rates and find that you can get a lower interest rate if you do a refinance. You also may be able to free up some cash to do that kitchen renovation you have been dreaming of.

In this scenario, you could refinance for more than the $80,000 that you owe. If you want to take out $50,000 cash, you might refinance your home for $130,000, which is the $80,000 loan balance plus the $50,000 cash you would get.

Of course, you need to prove to the lender that you can afford the new payments and can qualify for the loan in terms of credit and income.

Why Is a Refinancing a Popular Way to get Cash Back?

Most people opt for a cash out refinance to pay for home renovations. Done smartly, you can use your equity to increase the value of your home when you sell it later. Another popular option for getting cash out is to cover college tuition.

However, there are some reasons that you may not want to touch your first mortgage, as much as you want to tap the equity. For example, say that you took out your first mortgage in 2015 when 30 year fixed rates were well below 4%. You could be sitting pretty right now with a mortgage of 3.25%. There is nowhere in the United States you can get a 30 year fixed rate mortgage today for less than 4.5% at best. It does not look like rates are going to be declining in the near term either, as the Fed is continuing to promise rate hikes in a growing economy.

If that is the case for you, thinking about some other options to get that equity may be in order.

Alternatives to a Cash Out Refinance

Some of the other popular ways to turn equity into cash in your pocket are:

• Home equity line of credit or HELOC
• Home equity loan
• Reverse mortgage

A HELOC operates much like a credit card with your home serving as collateral. You have a credit limit just like with a credit card and you can spend up to that credit limit. The interest rate will vary with the prime rate, so know that you could be paying a higher rate in the future.

A home equity loan is a lump sum equity payment with a fixed rate. These are not marketed as much as a HELOC because the rate is higher. But with this type of second mortgage, you know what you will be paying exactly every month of the loan.

The other option for older Americans who own their home outright and are 62 or older is to pull cash from their home in a variety of ways. The balance does not need to be paid as long as you live in the home. The money that is taken out of the home is dealt with from the estate after you die.

Which Is Right?

When you do a cash out refinance, you will be paying interest for the life of the loan, which could be as long as 30 years. So, it is better if you spend your equity on a long-term purpose that will pay you back, such as a home renovation, or maybe a down payment on a second home.

It also rarely makes sense to take cash out for an interest rate at a higher rate than you are paying. If you cannot get a lower rate with a first mortgage refinance, consider a HELOC or home equity loan.

If you want to tap your equity to pay for a shorter-term goal, such as paying down debt, consider a home equity loan or HELOC. You will pay down that debt faster and the total interest paid will be lower.