Look Before You Leap: Risks of a Cash-out Refinance
I recently got an advertisement letter from a lending company letting me know that my property “may have significant appreciation due to the favorable market conditions and the increase in my city’s home values. An increase in the value of your home may provide you with an opportunity to refinance your home with [said lending company] and cash out the equity created by your home’s appreciation.” It went on to state that my “new interest rate” would be a mere 2.217% APR, emphasizing I can get a “Tax-Free” cash out. Sounds alluring, but is it best?
A cash-out refinance (COR for short) uses the equity in your home to secure a new larger loan. The new loan replaces your current mortgage, if you have one, and provides cash for your discretion. This is unlike a traditional home refinance that simply replaces your current mortgage with a new one of the same balance at a lower interest rate, a shorter term, or both. On the other hand, a COR allows additional cash to be withdrawn. The limit of that amount is generally 80% to 90% of the equity in your home.
The COR cash can virtually go towards any purpose. According to Freddie Mac, the most popular use is to pay off bills or other debt; home repairs or new construction is next, followed by increasing savings, buying a car, paying for college, and other financial needs. Some homeowners also use a COR to free up money to invest toward future expenses.
There are benefits of a COR. Interest rates are low right now and a COR may be the cheapest way to borrow money. Putting the cash towards home repairs or improvements may also increase the value of your home. Another option is to pay off high-interest loans like credit cards. This can save you many dollars in interest and can even improve your credit score. There may also be additional tax deductions you can claim.
Before you move forward with a COR, there are some real cautions and drawbacks that you need to be aware of. Just like the advertisement stated, home values in my neighborhood have risen and they probably have in your area as well. If you were to maximize a COR at the current value of your home, there is a chance this value is inflated. If mortgage values fall or revert to the mean, you could be upside down in your mortgage. Compound falling home values combined with an inability to repay the loan is a real risk of foreclosure. Hence, if you utilize a COR, don’t squeeze every last dollar out of your home that you can.
A second risk is not understanding the tax implications of a COR. The interest on the COR may not be tax-deductible. Yes, you can indeed use the additional cash for almost anything. However, to deduct the interest, you need to use it for a capital improvement on your home. Using the cash to paying off a high-interest credit card, help pay your child’s college education, take a dream vacation, or even fix your home’s HVAC system may sound like great options. Unfortunately, those expenditures don’t increase your property’s value and you can’t deduct the interest. In that case, you can only deduct the percentage of interest you paid on your original loan balance. IRS Publication 936 further details home interest deductibility.
Additional downsides of a COR include closing costs of typically 2% to 5% of the mortgage, the potential need to pay Private Mortgage Insurance by cashing out too much equity, and enabling bad spending habits by paying off high-interest credit cards. High closing costs and Mortgage Insurance premiums can add to your borrowing and quickly add up to thousands of dollars.
Your home should never be your piggy bank for your lavish purchases, no matter how tempting. Always make sure you have a sound use for the money you take out of its equity, don’t withdraw more than you need, and use the withdrawal for something that will better your financial situation. Realize that there are other options for getting needed cash like a Home Equity Loan or a Home Equity Line of Credit. There are additional pros and cons to both of those options. Before you engage in a cash-out refinance discuss your plans with an advisor who can give wise objective counsel. It can save you disappointment in the long run.
