Cash-out Refinancing Basics

Cash-out refinancing can help you consolidate debt. It is a useful tool, but it must be used in conjunction with controlling your spending.

What is cash-out refinancing?

It is the process of taking out a new mortgage with a larger principal than your current mortgage. The difference in principal is paid to you as cash, which you can use for almost any purpose, including debt consolidation.

How does it work?

Cash-out refinancing is based on your home equity, which is the part of the home that you actually own. For example, if you have a home worth $250,000, and you owe $200,000 on the mortgage, you have $50,000 worth of equity in the home. If you refinance, that $50,000 is available for you to use (depending on your lender’s rules).

What can you use the cash for?

You can use the cash in almost any way you want. One wise way to use it is to consolidate your debt. If you have high-interest credit card debt, you can usually get a much lower interest rate by using your home to secure the loan. For example, if you have $20,000 in credit card debt, you can use cash-out refinancing on your home and increase your principal by that same mount: $20,000. At closing, you get that $20,000 in cash and can use it to immediately pay off your credit card debt.

At this point, the debt is now wrapped up into your mortgage, but that can be advantageous to you. Instead of paying an exorbitant interest rate -- some credit cards are as high as 18 percent -- that is not tax deductible, you can pay a much lower rate – such as 6 percent -- and get tax benefits since the debt is tied to your mortgage.

Cash-out refinancing does not necessarily raise your monthly mortgage payment, although it certainly is possible that you could end up with higher monthly payments after refinancing in some situations. Your overall debt payment will be less, though, since you are not paying high interest to a credit card company.

What should I know first?

If you are considering cash-out refinancing, you need to be aware it only makes sense if you couple it with financial restraint. If you do not curtail your spending, cash-out refinancing can be a foolish move. If you use the money and then wind up running up more credit card debt later, you could find yourself in serious financial trouble: A larger debt on your mortgage plus even more credit card debt. Also, because the debt is now tied to your mortgage, you could lose your house if you fail to repay the debt.

Despite its risks, cash-out refinancing can still be a smart option if you need to get out from under high-interest debt, and you change your spending habits.

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