Cash-out refinance: When is it a good option?

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When you refinance your mortgage, you get a new mortgage to replace the current one. And if you have enough equity in your home, you can do a cash-out refinance.

What is a cash-out refinance?

A cash-out refinance is when you refinance your mortgage for more than you owe and take the difference in cash. It’s called a “cash-out refi” for short.

You usually need at least 20 percent equity in the property to be eligible.

How a cash-out refi works

Let’s say you bought your house a few years ago and have been making mortgage payments faithfully. While you’ve been paying, the home’s value has been rising, and now you owe $80,000 on a house that’s worth $250,000.

You have recently looked up mortgage rates and have discovered that you can snag a lower rate if you refinance. You also would like to free up cash to pay for home remodeling.

In this situation, you could refinance for more than the $80,000 you currently owe. If you wanted to take out $50,000 cash, you could refinance for $130,000: the $80,000 loan balance plus the $50,000 cash you would receive.

You would have to prove you can afford the monthly payments and otherwise qualify for the loan. And you would have to provide the usual documentation of income, assets and debts. Start out by comparing offers from lenders.

Reasons for cash-out refi

The most common reason for getting a cash-out refi is to pay for home improvements, says Rick Sharga, executive vice president and chief spokesperson at Carrington Mortgage Holdings, based in Anaheim, California. Home improvements are a good way to use equity because you’re adding to the home’s value, Sharga says.

Another popular reason to get a cash-out refi is to pay for college tuition, he says.

Alternatives to a cash-out refi

Doing a cash-out refinance is one way to turn your home equity into cash. Other ways of converting equity into cash are:

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

A home equity line of credit works like a credit card, with your house as collateral. You have a credit limit, just as you do with a credit card, and you can spend up to that limit. The interest rate moves up and down with the prime rate.

A home equity loan is a lump-sum loan with a fixed interest rate. Home equity loans aren’t marketed as aggressively as HELOCs, which outnumber home equity loans about 4-to-1, according to CoreLogic.

A reverse mortgage allows homeowners age 62 and up to draw cash from their homes in various ways. The balance doesn’t have to be repaid as long as the borrower lives in the home.

Which is right for you?

When you get a cash-out refi, you’ll pay interest for the life of the loan, which could be 15 or 30 years. So, it’s best to spend your cash-out refi money on a long-term purpose, such as for home renovations or to free up money for a down payment on a second home.

On top of that, it rarely makes sense to get a cash-out refinance at a higher interest rate than what you’re currently paying. If you can’t snag a lower interest rate, it’s often better to keep the current mortgage and take cash out of your home via a home equity loan or HELOC.

Similarly, if you want to spend the money on a shorter-term purpose — to buy a car or consolidate credit card debt — it’s usually better to get a home equity loan or HELOC. Why? Because you’ll pay those off faster, and your total interest paid will be lower.

But if you want to use your home’s equity to pay off credit card debt, be aware that you could lose your home if you don’t repay.