Back in the pre-recession days – say, four or five years ago – “cash-out” refinancing was all the rage. This move can still make sense today, but there are often better alternatives.
The cash-out refi is simple: Say your home is worth $400,000 and you owe $250,000. Since lenders typically allow mortgages as large as 80% of the property’s value, you could take out a new loan for $320,000 and have $70,000 left after paying off the old loan.
With today’s 30-year fixed-rate mortgage interest rate down to a mere 4.4%, you could use that cash to pay off high-interest credit card debt, to remodel your home, or for some other purpose.
But keep a few points in mind:
First, it’s generally unwise to take on long-term debt for short-term needs. A 4.4% mortgage rate is a terrific deal for buying a house, which is a long-term holding, but over 30 years you’ll pay about $800 in interest for every $1,000 borrowed. If you bought a $30,000 car on those terms you’d pay $54,000 in interest and principal over the life of the loan. You’d still be paying long after the car was worthless.
Second, add in the costs of taking out the loan. Things like title insurance and application fees can come to 3% to 6% of the loan amount. That’s OK if the refinancing reduces your mortgage rate substantially, as the saving will offset the costs in a few years.
But if there is no substantial rate reduction, it would not pay to refinance just to get at cash locked up in the home. You wouldn’t want to pay $10,000 to get a new mortgage just to buy a car with a low-rate loan. Even if you were to pay off a 20% credit-card balance with a new, 4.4% mortgage, once refinancing fees were considered, the savings might evaporate.
Third, consider the alternatives. You might pay only a few hundred dollars in application and appraisal fees for a fixed-rate home equity installment loan or floating-rate home equity line of credit. Five-year installment loans currently charge about 7%, and many HELOCs charge 5% to 6% after the initial, lower rate expires.
Because a home equity loan is separate from the mortgage, the payments would end as soon as you pay off the balance. In a cash out refinancing, you’d have to pay for that extra cash for the life of the mortgage.
Another alternative is to tighten your budget to save for the purchase you’d make with the cash-out refinancing, or to pay off your credit card debts faster. Use the BankingMyWay Credit Card Payoff calculator to devise a plan.
Finally, if you do opt for a cash out refinancing, consider making extra principal payments whenever possible to trim the debt ahead of schedule. With a fixed-rate loan, this will not reduce the required payments, but it will allow you to pay the mortgage off early, saving a bundle in interest charges over the years.
In effect, those extra payments earn a return equal to the mortgage rate, which is probably better than you can earn in bank savings.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.