The pandemic housing boom means American homeowners are sitting on a huge pile of home equity. Lenders allow you to pull some of that money out of your home through a cash-out refinance.
In a cash-out refinance, you retire your existing mortgage and withdraw a portion of your home’s equity in a lump sum. As with any financial decision, a cash-out refi comes with advantages and disadvantages.
Cash-out refinance: Pros and cons
- Access to a big chunk of cash: The biggest upside of a cash-out refinance is that you get the money you need to upgrade your home or pay down debt by unlocking the equity you already have.
- Predictable payments: Most borrowers who take cash-out refinances do so with 30-year fixed-rate mortgages. That means you know how much your monthly payments will be. That’s not the case with other options for tapping home equity — many home equity lines of credit, for example, carry variable, rather than fixed, rates.
- Upgrades can boost your home’s value: Depending on the type of renovation you fund with your cash-out refi, the improvements could increase the value of your property and further build your equity. Kitchen and bath remodels are especially effective on this front.
- Potential tax deductions: Renovations can also make a difference when you file your taxes. In general, you can deduct the interest you pay on the mortgage so long as you use the funds to make improvements that add value to the home. Improvements can also increase your tax basis in the house, which will reduce your capital gains tax liability when you sell.
- Mortgage debt is “good debt”: For most consumers, mortgage debt is the cheapest form of money available. Compared to credit cards, personal loans and other types of debt, mortgages offer a combination of low interest rates and favorable terms.
- You owe more: With a cash-out refinance, your overall debt load will increase. No matter how close you were to paying off your original mortgage, the extra cash you obtained to pay the contractor is now a bigger financial burden. This also reduces your proceeds if you were to sell.
- Closing costs: Just as you had to pay closing costs on your original mortgage, you’re going to need to pay similar expenses when you refinance. Those can be significant — the credit check, appraisal and other costs can add up to 2 percent to 4 percent of the loan amount.
- You need plenty of equity: Lenders generally require you to maintain at least 20 percent equity in your home (though there are exceptions) after a cash-out refinance, so if you bought recently with a low-down payment loan, you might not qualify.
- You might be kicking your debt can down the road: Financial experts say tapping home equity to pay for renovations is a wise move. But if you’re cashing out to pay off high-interest debt on credit cards, take a long pause. Make sure you’ve addressed whatever spending issues led you to run up the debt in the first place. Otherwise, you might find yourself in a debt spiral.
- Unexpected tax implications: With a cash-out refinance, you take on additional mortgage debt, which can increase your tax liability. Be sure to consult with your accountant.
When cash-out refinancing isn’t worth it
If you’re concerned about the impact of cash-out refinancing on your long-term financial health, think about your future plans.
If you expect to sell your home in the near future, for example, it might not make sense to refinance for a cash-out loan. After all, you’ll have to repay the larger balance at closing.
This is something of a gray area, though. If your kitchen is decorated in 1970s-vintage Formica counters, vinyl flooring and wallpaper, then maybe using the cash-out proceeds to update will boost your home’s value enough to recoup the costs.
A cash-out refinance can be a smart way to pay for home improvements and renovations, but you have to have adequate equity in your home, and ideally, get the lowest possible rate.
You can use Bankrate’s loan-to-value (LTV) ratio calculator to have a solid grasp on how much you owe on your existing mortgage. Then, you can add up the projected costs of your home renovation to see how much you need to turn your current home into your dream home.