A cash-out refinance happens when a loan is taken out on a property for more than the amount owed on it to pay off existing liens and expenses related to the property. Technically, any refinancing of a debt is a cash out when the cash is used to pay off anything other than the related debt. Cash-out refinancing, though, is specifically when an equity is liquidated in a sum way higher than the amount of the existing loan. For instance, if a homeowner owes $90,000 on a property that is valued at $200,000, he has $110,000 in equity. He can liquidate the $110,000 with a cash-out refinance loan as long as the loan amount is greater than $90,000. A cash-out refinance replaces the first mortgage and has interest rates that are generally lower than a home equity loan. The new mortgage amount is bigger than the existing mortgage amount and factors in loan settlement costs. For a cash-out refinance, you will have to pay closing costs which can go up to several hundred or even thousands of dollars. Of course, money from a cash-out refinance is not taxable since you will be paying it back but will have to deal with larger monthly mortgage amounts. So, to put it in simpler terms, a cash-out refinance pays the difference of the balance of your mortgage and the value of your home while having higher interest rates because of the higher loan amount. With this kept in mind, let’s look at some of the pros and cons of a cash-out refinance:

Pros of a cash-out refinance

A cash-out refinance is an excellent way to access money that you own that is not in liquid form. By liquidating it, you can pay off large bills that relate to college, health business or home improvements. It has an appealing interest rate, often lower than what you would get on personal loans, credit cards or student loans. A cash-out refinance is also one where you get a refinance in order to pay off or consolidate credit card debts. David Cary, a mortgage broker for C2 Financial Corp., has clients among who the cash-out refinance to pay off or consolidate credit card debts is popular. This is a huge benefit of cash-out refinancing. Cary generally examines the average interest rate on a credit card of the borrower and determines whether moving the debt to a mortgage will get the borrower a lower rate of interest. A borrower can also use some of the liquidated equity to pay off the debt and seeing that it is tax exempt, sometimes, a huge amount in debt that is not part of the mortgage can be taken care of according to Cary. Paying off your credit cards in one fell swoop with a cash-out refinance can vastly improve your credit scores. You will also get a bigger tax refund with cash-out refinances because they reduce your taxable income. Another advantage of a cash-out refinance is that it gives more stable rates. According to Scot Sheldon, a loan officer, many of his clients take a cash-out refinance in order to do home improvements because cash-out refinancing provides a steadier rate of interest which they prefer over adjustable rates of interest.

Cons of a cash-out refinance

Cash-out refinances definitely have some disadvantages. While they offer lowered interest rates than the current mortgage, the interest rate will still be higher than a regular refinance. Also, cash-out refinances are quite cumbersome requiring documents like past two years of tax returns, two years of W-2 forms, pay stubs for a month, two bank account statements that are recent, and more. It is also pricey because of the closing costs that have to be paid at the end of the refinance. Closing costs can vary anywhere from hundreds to thousands of dollars based on a large variety of factors. Also, should the value of housing ever go down, taking out an equity puts you at a greater risk overall. You will end up owing more than your house is worth. Federal Reserve studies claim that cash-out refinances have a higher rate of default than regular finances. So if you default on payments, you put your home at a risk of foreclosure. Another disadvantage is that cash-out refinances usually come with their own set of terms which may vary from the terms of your original loan. Ensure you check and recheck interest rates and other fees before you go for one. Then, there is the issue of private mortgage insurance where if you borrow more than 80% of the value of your home, you will have to pay for a private mortgage insurance which, in turn, increase the total amount you have to pay off.

Remember, since your home is your collateral, it is important to make payments in time should you go for a cash-out refinance.