Why You Should Consider a Cash-Out Refinance Despite Rising Interest Rates
When the Federal Reserve changes the rate at which banks borrow money, many consumers feel the impact. Interest rates on credit cards, student loans, home equity loans and mortgages move along with the Fed. When rates go up, it tends to discourage homeowners from refinancing.
Interest rates in the U.S. have been on the rise for a while now, but that doesn’t appear to have slowed cash-out refinancing. According to the latest numbers from Freddie Mac, U.S. homeowners cashed out $69.7 billion in home equity in 2017, up from $60.9 billion in 2016.
Are these homeowners making a huge mistake? Maybe not. There are some good reasons to consider a cash-out refinance despite rising interest rates.
Reasons to get a cash-out refinance, even when rates are rising
When does it make sense to take a cash-out refinance? Let’s look at some situations in which it may be a smart move, despite rising interest rates.
Interest rates are lower than the one you have
Even with interest rates on the rise, it’s not a given that the interest rate you’ll receive will be higher than the one you now have. If you have an older mortgage, or if your credit score has improved since you last took out a mortgage, you may be able to qualify for a lower interest rate than you’re paying.
The cash will be used to improve the property
In a cash-out refinance, you refinance your existing mortgage into a new loan with a higher balance and take the excess proceeds out in cash to use as you wish. But if you use the proceeds to pay for home renovations, you may be able to take advantage of some tax breaks.
Under the Tax Cuts and Jobs Act, interest on home equity loans is no longer deductible, unless proceeds of the loan are used to buy, build or substantially improve the home that secures the loan. If you use the money to renovate your home, you may be able to increase the equity in your home and partially offset your mortgage payment with an increased tax deduction.
Keep in mind that tax reform also lowered the dollar limit for total deductible home loan interest from $1.1 million to $750,000. You’ll need to itemize deductions to take advantage of the deduction. If you’re not sure how this will affect your tax situation, it’s a good idea to get advice from your tax professional.
It’s the lowest-cost alternative
If you need to borrow money to start a business, consolidate higher-interest debt, pay school tuition or for any other reason, debt secured by your home is typically one of the lowest-cost options available.
A cash-out refinance usually carries a lower rate than unsecured credit cards or personal loans. If you run into financial difficulties and cannot make your mortgage payment, you run the risk of losing your home in foreclosure.
You need stability in your interest rate
A home equity line of credit (HELOC) also allows you to tap your home’s equity, but interest rates on a HELOC are typically adjustable, whereas interest rates on a cash-out refinance may be fixed or adjustable.
In a time of rising interest rates, borrowing with a HELOC can be risky. As interest rates rise, so will your monthly payment. With a fixed-rate cash-out refinance, your interest rate will remain the same no matter what’s going on in the market.
Cash-out refi costs to consider
Anytime you refinance your mortgage or borrow against your home’s equity, you’ll most likely have to pay closing costs and fees. While those vary by lender, they typically run around 2% to 6% of the amount borrowed.
“The biggest cost to consider when doing a cash-out refinance are the points being charged to obtain a particular interest rate and the lender’s stated processing, document and underwriting charges,” said Regan Hagestad, vice president of Watermark Home Loans in the Los Angeles area. Those items can vary widely from lender to lender. “The title charges, escrow charges, transfer charges and recording fees should be fairly nominal and very similar from lender to lender,” Hagestad said.
Alternatives to a cash-out refi
Before you proceed with a cash-out refinance, consider these alternatives.
A cash-out refinance lets you tap your home’s equity in a lump sum, but if you want flexibility in the amount you’ll borrow and when, a HELOC may be a better fit. A HELOC is similar to a credit card in that it’s a revolving line of credit that you can borrow against over and over again during the loan’s borrowing period.
The upside of a HELOC is that you only use what you need when you need it. You don’t have to pay interest unless you withdraw the money.
“Home equity lines are great for smaller dollar figures or when you have exceptional terms on your existing mortgage,” Hagestad said. “For example, if you owe $250,000 on your existing home at a rate of 3.5% and are looking to get $15,000 to do a remodel, then a HELOC would be the right fit.”
Home equity loan
A home equity loan is also known as a second mortgage. You keep your existing mortgage but borrow against your home’s equity in a one-time event. Interest rates on a home equity loan are typically fixed. But rates are usually higher than those you would receive from a HELOC or a cash-out refinance.
Again, a home equity loan might make sense if the interest rate on your existing mortgage were so good that refinancing and losing your lower interest rate wouldn’t make sense.
Personal loans are unsecured, so you don’t have to put your home up as collateral. That’s a benefit if you’re worried about putting your home at risk in the event you run into financial troubles and can’t pay your mortgage. But without any collateral backing the loan, personal loans typically come with higher interest rates.
Also, personal loans typically come with shorter terms than mortgages. Personal loans are usually repaid over two to seven years, where a cash-out refinance may have a term of 15 or 30 years. If you need to borrow a large amount, the shorter repayment period could make the monthly payments on a personal loan unaffordable.
The bottom line
In a rising interest rate environment, a cash-out refinance can offer the security of rate stability and an affordable way to borrow. That makes it a good option, especially if you can lower your interest rate and use the proceeds to increase the value of your home. But before you put your home at risk, compare all available alternatives. If your monthly payment will increase with the new loan, make sure the higher payment won’t impact your ability to repay the loan and meet your other financial goals.