Cash-Out Refinance? What is it and does it make sense?

Many American homeowners have seen their property values rise over the past few years which creates additional equity in the property. See below for an example of how rising home prices creates additional equity:

Lets say that you purchased your home in 2015 for $100,000 with a $20,000 down payment and an $80,000 mortgage. At this time your equity in the house is $20,000. This would mean that if you sold the house for $100,000 a week later (ignoring all selling expenses for simplicity) you would receive $100,000 in cash. $80,000 of the cash received would go to pay off the mortgage and you would keep the remaining $20,000 as that is your equity in the house.

Basically equity can be thought of as the money that you would have left over after you sold the house and paid off the loan and any additional costs.

Since people usually don't buy a home and sell it in a week unless maybe they are a house flipper lets use the same purchase scenario above and fast forward 5 years. In the last 5 years lets say your house now appreciated in value and is now worth $140,000 and since you have been paying down your mortgage lets say the mortgage balance is now $75,000. Now your equity in the home is calculated by subtracting the $75,000 mortgage balance from the $140,000 market value which equals $75,000! So if you sold the house now (ignoring all selling expenses for simplicity) you would receive $75,000 after the mortgage payoff. Not a bad for 5 years.

What if you want to access your increased equity in your home but do not want to sell the home? One way to do this is a Cash-Out refinance. Now that your home has appreciated and you now have more equity you can goto a bank and they will allow you to refinance your loan using the new appreciated value! Doing this will allow you to take out a larger mortgage which will give you access to some of the $75,000 in equity that you now have in your home. See below for an example:

Since the home is worth $140,000 now most banks will allow you to refinance up to 85% of the homes value. This means that you would be able to get a new mortgage for $119,000. The new $119,000 mortgage would allow you to pay off your current mortgage of $75,000 and anything left over you would get to take home in cash! In this case you would get $44,000 in additional cash from the refinance (this calculation for simplicity is also ignoring any refinance costs).

Now you may think this is all great I can just get an extra $44,000 right? The examples above are used just to illustrate the general concept and do not take into account interest rate differences or fees which also need to be considered when refinancing.

For example if your $75,000 loan had an interest rate of 3% and the new loan would have an interest rate of 7% you probably would not want to refinance as the new loans interest rate would cost you in the long run. You also have to consider the fees associated with refinancing which will lower the amount of proceeds that you would receive.

Lets look at an example where the $75,000 loan has an interest rate of 7% and current market rates are at 3%. This scenario would most likely make sense to refinance as the interest rate on the new loan is significantly lower than the old loans interest rate and would save you interest costs in the long run.

Another scenario where it may make sense to cash-out your equity by refinancing is if you are going to invest the money in an asset that is expected to earn a higher rate of return then the new mortgage rate. This can be a profitable strategy but can also be risky. If the investments you select with the money from the refinance do not end up covering the cost of the mortgage you will lose money.

In the worst case scenario lets say you made bad investments and you lose all of your money. In this case you are still on the hook for the additional money borrowed but no longer have any investment income to cover the costs which means you will have to pay the mortgage with other funds. If you do not have other funds to cover the increased mortgage you may lose your house! If you are going to pursue an aggressive strategy like this you should do extensive due diligence on the investments that you are going to make and also diversify as much as possible so if one of the investments goes bad then it will not devastate your ability to fund the additional loan costs.

An example of a common reason to refinance your primary residence is to fund the purchase of a rental property when you do not have enough cash available to make the necessary down payment. Obviously only consider this if you have the proper knowledge or experts to guide you as there are many costly mistakes that can be made.

It is also not a great idea to refinance just to spend the money on things such as lavish vacations etc. These items do not create any value or income and you will be stuck paying the increased mortgage for many years after you spend the money!

The decision to refinance your home can be very complex and anyone considering doing so should either consult an expert or have the financial knowledge to make an informed decision. The ability to understand the risks and rewards in these transactions is critical to avoiding a serious mistake that could haunt you financially for decades!

There is another option to gain access to the equity in your home on an as needed basis which works similar to a credit card but has a lower interest rate. This option is called a Home Equity Line of Credit or HELOC. A bank will allow you to access your additional equity in your home using a HELOC and the amount allowed is determined similarly to a refinance. The main difference between a HELOC and a refinance into a fixed rate mortgage is that it typically has a variable interest rate which means that if interest rates suddenly go up your payments will also increase. HELOC's can be a great option if you need cash for a short period of time in an emergency as the interest rates are typically much lower than a credit card. They also only charge interest when you have an outstanding balance. For example if you have a $40,000 HELOC and never draw money from it you will not be charged any interest. If you do draw money from it for a period of time you will only be charged interest for the time the money is drawn. A HELOC can be a great safety net for families as it allows for quick access to funds in a time of need at reasonable interest rates.

Disclaimer:
This article is for informational purposes only and should not be considered legal, financial, accounting or tax advice. Anyone considering a refinance should consult an expert in the field or have the necessary knowledge to fully understand the transaction and possible risks.