Pros and cons of a cash-out mortgage refinance

If you've been following the news lately, you know that mortgage rates are at historic lows amid the coronavirus pandemic. Typically, when mortgage interest rates are low, borrowers refinance in order to lower their monthly payments. However, with a cash-out mortgage refinance it’s also possible to use the equity that you’ve built up in your home to cover a big expense.

Pros of a cash-out mortgage refinance

Like any type of financial move, doing a cash-out mortgage refinance has its own pros and cons. In order to help you decide whether this type of refinancing is right for you, we’ve laid them out below. Keep reading to learn more.

1. Lower interest rates
2. Pay down other debts and improve credit
3. Possible tax deductions

1. Lower interest rates

The good news is that low interest rates aren't just for new homebuyers. Mortgage refinance rates are at historic lows as well. If it's been a while since you first took out your home loan, there's a good chance that you can cash in on the record low refi rates and secure a much lower rate on your new mortgage.

Put simply, low rates matter when it comes to your monthly payment. In a cash-out refinance scenario, if the rate on your refinance mortgage is much lower than your original rate, you may be able to leverage the equity in your home while still making a payment that is similar to the one you're paying now.

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2. Pay down other debts and improve credit

Aside from taking advantage of the low mortgage refi rates, doing a cash-out mortgage refinance can help you pay down other debts. In this case, you borrow more money than you currently owe on the home and the difference is given to you in cash. After the refinance is done, you can use the money however you see fit, including to pay off existing debt.

Best of all, paying off your debts may even help you improve your credit score. After all, your credit utilization ratio, or the measure of how much credit you're currently using compared to how much you have available, accounts for 30% of your credit score. When you pay off your debts your ratio will be lower, which means that your credit score should go up.

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3. Possible tax deductions

Luckily, when you do a cash-out refinance, the IRS does not view the money that is given to you as income. Instead, it views the money as an additional loan, which means that you may be able to deduct the interest from your cash-out refinance on your taxes.

In this instance, many of the tax implications depend on how you intend to use the money. IRS Publication 936 covers the particulars of the home interest tax deduction in detail. In general, though, you can only deduct the interest if you put the money towards an improvement that significantly increases the value of your home.

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Cons of a cash-out mortgage refinance

While there are certainly many benefits of a cash-out refinance (like the ones listed above), there are also some aspects that may give you pause, such as:

1. Closing costs
2. Potential PMI
3. Run the risk of using your home like a bank

1. Closing costs

One of the biggest disadvantages of doing a mortgage refi is that this move does come with closing costs. Remember, when you refinance, you’re essentially taking out a new loan to pay off your existing one.

Just like when you took out your first mortgage, you’ll be responsible for covering the costs and fees necessary to close on your new loan. Typically, your closing costs will amount to between 2% and 5% of the loan amount.

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2. Potential PMI

Depending on how much you borrow, you may also have to budget for additional costs, like private mortgage insurance (PMI). Whenever you have less than a 20% stake in the home, lenders will require you to carry PMI. If you want to avoid this additional fee, be sure to ask your lender how the amount that you are borrowing will affect your loan-to-value ratio.

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3. Run the risk of using your home like a bank

Lastly, once you do a cash-out refinance, you run the risk of seeing your home like a bank or ATM rather than your largest asset. Generally, mortgage refinance servicers recommend only using a cash-out refinance to cover big, one-time expenses, like renovation costs, medical debt or education costs.

The bottom line

If you’re interested in taking advantage of the current refinance rates while saving on mortgage payments or leveraging the equity in your home, your best bet is to talk to a mortgage lender.

THIS MORTGAGE RATES MISTAKE COULD COST YOU THOUSANDS