Whenever interest rates drop dramatically, enthusiasm for mortgage refinancing rises. Homeowners look into lowering their payment or slashing years off their mortgage—and sometimes they can achieve both.
One popular option during a refinance is to borrow more than you need to pay off the old mortgage and take the surplus in cash. You don't have to pay taxes or penalties on the cash you pull out of your home this way, unlike when you get money from a 401(k) or an IRA. You do, however, have to pay closing costs for the new loan.
"This is your equity. It's your money," explains Rodney Anderson of Supreme Lending. A cash-out refinance "is one of the best ways to get out of credit card debt, do home improvements, or send the kids to college."
A smart cash-out refi has these three features:
- Loan term stays the same.
- Payment stays the same.
- Cash goes to home repairs or another wise use.
Let's take a closer look at each of these features.
The Loan Term Stays the Same
If the new mortgage adds years of debt to your life, then the cash didn't really come from your equity, at least not all of it. You'll be spending those additional years paying back the cash. That situation is not so much a cash-out refinance as a "cash-to-be-repaid-later refinance."
A sign of a smart cash-out refi is your loan term stays the same. If you refinance a 30-year mortgage at the 22-year mark, look into a new mortgage of 22 years to match. A responsive lender will adjust the loan term to suit your needs, whether it's 25 years, 21, or 18. If you're close to the 15-year mark, you can take advantage of some of the lowest rates available because the 15-year fixed-rate mortgage is a prime attraction in the refinance market.
Interest accumulates to a surprising degree over the years, so try not to add years to your mortgage. Adding years would push the finish line farther away, and you'd rack up a lot of money in interest reaching it.
The Payment Stays the Same
The power of a lower interest rate is that you can borrow enough to pay off the old mortgage, add $40,000 or $50,000 to use as cash, and keep your payment the same. There will be closing costs for the new mortgage, but you still come out way ahead.
For example, let's say that eight years ago you borrowed $325,000 at 4.39%, a competitive rate at the time. Your payment has been $1,626. You currently owe around $277,000.
Now with 22 years to go on that mortgage, you seize the opportunity to refinance. You borrow $317,000 at 2.89% so that you can pay off the old mortgage and take $50,000 in cash. The new mortgage term is 22 years to match the old. Your payment is the same, $1,624 (it actually went down a couple of bucks).
Even after paying the closing costs (say, $8,000) up front, you net $42,000 in cash. Where did the money come from? It came from your home. Because the loan term and payment didn't get higher, it's clear that the cash came from your equity like it's supposed to.
Have a Plan for the Cash
Since a mortgage refinance takes time and paperwork, and you will have to pay closing costs, don't get started unless you have a wise plan for the cash. Home repairs are a good use because money generated by your equity gets reinvested in the home. Repairs and maintenance preserve your home's value.
Paying off credit cards (not just paying them down, but paying them off) is another good use of a cash-out refinance. "The number one reason that people can't sleep at night is credit card debt," says Anderson. Once you've paid off the cards, keep the balances low enough that you can pay them in full every month. When you never float a balance, you never pay a dollar in interest.
Among other wise uses for a cash-out refinance are sending the kids to college, buying solar panels that will pay for themselves in five or six years, or raising home value with an additional bathroom. Unwise uses include gambling, shopping sprees, and getting in on a "sure thing" in the stock market.
Whatever your reason for taking cash out of your home with a mortgage refi, remember not to add years to your debt and to keep the payment the same. Both are hallmarks of a smart mortgage refinance.
- Reap the most benefit from a cash-out refinance by not adding years.
- With rates as low as they are, you can probably keep your payment the same. The cash should come out of your equity, not out of higher payments.
- Have a good plan for the cash. This is not mad money.