According to Freddie Mac's most recent quarterly refinance survey published August 1, 23% of all refinance loans in the second quarter involved a cash out that increased the borrower's mortgage balance by at least 5%.
Does 23% sound high? Consider the historical percentages: from 1985 through 2010, nearly half of borrowers took cash out when they refinanced. (To learn more about refinancing, read When (And When Not) To Refinance Your Mortgage.)
TUTORIAL: Mortgage Basics
Everyone who cashes out may think they have a good reason, but this type of refinance isn't always in borrowers' best interests.
How Cashing Out Is Different
In an ordinary refinance, the primary purpose of refinancing is to obtain better loan terms. "Better" often means a lower interest rate, a shorter term or a predictable monthly payment like a fixed-rate loan rather than an ARM. The borrower keeps the amount of money he or she owes on his or her house the same, but receives a new interest rate and loan term. For example, if the borrower has $175,000 remaining on his or her current 30-year fixed, 7.0% mortgage for a home that he or she purchased for $250,000, he or she might refinance the $175,000 for 15 years at 4.5%.
He or she would still have the same amount of equity after refinancing that he or she had before refinancing.
However, if the borrower were doing a cash-out refinance, he or she might refinance $200,000 for 15 years at 4.5%, increasing his or her loan balance by $25,000. Since there is only $175,000 remaining on his or her old loan, when that loan is paid off, he or she receives the $25,000 difference in cash. The $25,000 has to be paid back at 4.5% interest over 15 years under his or her new $200,000 mortgage. The monthly payment is higher and the borrower will pay more interest, but also has $25,000 more in the bank.
Advantages of Cash-Out Refinancing in Today's Market
There are some ways in which borrowers currently doing cash-out refinancing are making a smart move:
- They're borrowing money at record-low interest rates.
- They're borrowing money at the lowest interest rate available. Home equity loans and home equity lines of credit have higher interest rates than first mortgages.
- Mortgage interest is tax-deductible. The interest on other types of loans, like personal loans, credit card loans and auto loans, is not.
The question is what homeowners are doing with their cash-out money, which is beyond the scope of Freddie's survey. (To help you determine if an interest rate drops is your sign to refinance, read Should You Refinance Your Mortgage When Interest Rates Drop?)
Problems With Cashing Out
Cash-out refinancing has many potential downsides:
Increasing the amount and term of your mortgage, even while lowering the interest rate and possibly lowering the monthly payment, can increase total borrowing costs. When you start your mortgage back at month one, most of your payments go toward interest. Cashing out means that not only are you losing equity in your home, but it will take years to reestablish that same amount of equity again, let alone build on it.
- Decreasing your equity position increases your chances of ending up underwater on your mortgage, which can make it difficult to sell.
- A cash-out refinance can lengthen the number of years for which a borrower has mortgage payments, and mortgage payments tend to take up the largest percentage of borrowers' monthly income.
- The cash seems like free money, but it isn't. People often mismanage windfalls. Cashing out could entice you to live beyond your means and spend the money frivolously.
- Homeowners who cash out to repay high-interest debt sometimes rack up new debt and end up worse off.
- The home remodeling projects that people often use their cash for often don't earn a return on investment. In fact, from a purely financial standpoint, they're usually a losing proposition.
- Refinancing has much more expensive closing costs than the alternatives: home equity loans and home equity lines of credit. If your primary purpose is to borrow money, refinancing is often not the best way to get cash.
The Bottom Line
When you take money out of one long-term investment (in this case, your house), it's a good idea to put it into another long-term investment. Using the money for a shopping spree or a vacation, and even for home improvement projects, will set you back financially in both the short and long term. There are some situations where cashing out can help borrowers come out ahead, but there are more ways to use the money unwisely. If you want to cash out, make sure you're doing it for the right reasons and that you'll be helping yourself financially in the long run. (If you are considering refinancing your home, read 6 Questions To Ask Before You Refinance.)