Is a Cash-Out Refinance the Right Choice For Me?

Norah Tanner with Houzd Mortgage is back to break down how a cash-out refinance can help you pay off debt and what you need to consider to make it a successful part of your financial plan. Or if perhaps it is not the right choice for your situation.

Are you struggling with high-interest debt and looking for ways to get a handle on it? One potential solution is a cash-out refinance, a popular financial tool that allows homeowners to tap into the equity in their homes to pay off debt. If used wisely, this strategy can offer a way to consolidate debts, lower interest rates, and streamline monthly payments. However, it’s important to fully understand how cash-out refinances work and the potential risks involved before deciding if this is the right move for you.

What Is a Cash-Out Refinance?

A cash-out refinance is a mortgage refinancing option where a homeowner replaces their existing mortgage with a new one for a larger amount. The difference between the new mortgage amount and the balance of the old mortgage is given to the homeowner in cash. Essentially, you’re borrowing against the equity you’ve built up in your home, and you can use that cash for any purpose—whether it’s home improvements, investments, or, in this case, debt repayment.

How Does a Cash-Out Refinance Help With Debt?

Here’s how a cash-out refinance can be used to pay off debt effectively:

• Debt Consolidation - If you’re carrying multiple debts—such as credit cards, personal loans, and car loans—a cash-out refinance can help consolidate these debts into one payment. Rather than managing multiple due dates you can use the cash from your refinance to pay off those balances. This means you’ll have only one loan to manage: your new mortgage.

• Lower Interest Rates - One of the biggest advantages of using a cash-out refinance to pay off debt is that mortgage rates are typically much lower than the interest rates on credit cards or personal loans. For example, while credit card interest rates can easily be in the 15-25% range, mortgage rates might be in the 6-7% range. By using a cash-out refinance to pay off high-interest debt, you can significantly lower your interest payments and save money over time.

• Simplified Monthly Payments - Juggling multiple debts can be stressful and overwhelming, especially when they have different terms and due dates. A cash-out refinance streamlines your debt into a single payment. This can simplify your financial life, making it easier to budget and plan, and reduce the likelihood of missing payments or accruing late fees.

• Extended Repayment Term - Mortgages typically have longer repayment terms (15 or 30 years) compared to other types of loans. When you consolidate your debt into your mortgage, you spread the payments over a longer period. This can lower your monthly payments, providing immediate financial relief. However, it’s important to remember that extending your debt over a longer period can also mean you’ll pay more in interest over time, even at a lower rate.

Example of How It Works

Let’s break this down with a simple example. Say you have $30,000 in high-interest credit card debt and your current mortgage balance is $200,000. If your home is worth $400,000, you have $200,000 in equity. You could take out a cash-out refinance for $230,000. Of that amount, $200,000 would go toward paying off your existing mortgage, and you would receive $30,000 in cash to pay off your credit card debt.

This way, you’ve effectively replaced your high-interest credit card debt with a lower-interest mortgage. You now only have one loan payment to worry about, likely at a much lower interest rate than you were paying on your credit cards.

Important Considerations

While a cash-out refinance can be a smart way to pay off debt, there are some important considerations and potential risks to keep in mind.

• Risk of Losing Your Home - When you roll unsecured debt, like credit cards, into your mortgage, you’re essentially securing that debt with your home. This means that if you fail to make payments, you risk losing your home to foreclosure. Be sure that the new monthly payment is manageable before proceeding.

• Closing Costs - Just like with any mortgage, a cash-out refinance comes with closing costs, which can range from 2% to 5% of the loan amount. These costs can add up, so make sure to factor them into your calculations to determine if refinancing makes financial sense.

• Temptation to Accumulate More Debt - One of the biggest risks of using a cash-out refinance to pay off debt is that some people are tempted to run up new debt on their now-empty credit cards. If you’re using a cash-out refinance as a way to gain control over your finances, it’s essential to develop good financial habits and avoid the temptation to take on more debt.

• Lengthening Your Mortgage Term - While extending your mortgage term can lower your monthly payments, it could also mean you end up paying more in interest over the life of the loan. For instance, if you turn a 15-year mortgage into a 30-year mortgage, you’re spreading the payments out over a much longer period, which could lead to higher overall costs.

When Is a Cash-Out Refinance a Good Idea?

A cash-out refinance can be a good option in the following situations:

• You have high-interest debt. If your credit cards or personal loans have interest rates significantly higher than current mortgage rates, refinancing to pay off debt can save you money.

• You have substantial home equity. This option works best for homeowners who have built up significant equity in their homes, which means the home’s value is much higher than the amount owed on the mortgage.

• You have a plan to avoid future debt. Paying off your current debts won’t help in the long run if you don’t have a plan to avoid racking up new ones. Use this opportunity to get your financial habits on track.

Alternatives to Cash-Out Refinancing

If you’re not sure that a cash-out refinance is the best option for you, there are alternatives to consider, such as:

• Home equity loan or home equity line of credit (HELOC) - These allow you to borrow against your home’s equity but may come with fewer upfront costs than refinancing.

• Personal loan - If your debt isn’t too large, a personal loan with a lower interest rate than your current debt could help without involving your mortgage.

• Balance transfer credit card - Some balance transfer cards offer 0% interest for an introductory period, giving you a chance to pay off debt without interest accumulating.

Final Thoughts

A cash-out refinance can be a powerful tool for paying off debt and regaining control of your finances, but it comes with risks. If you have substantial home equity and are committed to improving your financial habits, it can offer relief from high-interest debt and simplify your monthly payments. However, if not handled carefully, you could end up putting your home at risk or even accruing more debt in the future. Before moving forward, carefully evaluate your financial situation, your goals, and whether this strategy aligns with your long-term plans.

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