Some people will tell you a cash-out refinance is a bad thing. And it's true that it's rarely wise to use your home as an ATM by refinancing every time you feel strapped for cash or want to buy something expensive. The trouble with dollars (why hasn't anyone fixed this obvious product defect?) is that you get to spend them only once. And if you are constantly frittering away the appreciating value of your home on luxuries or an unsustainable lifestyle, there's a high chance you're going to come to regret that when you actually need cash.
But refusing to ever use your personal ATM on principle can be as harmful to your wealth as doing so too often. There are times when a cash-out refinance can be smart. Here are four:
1. When You're Paying Too Much for Other Debt
Have you seen the interest rates charged on plastic nowadays? Even if you're lucky enough to qualify for low interest credit cards, you're likely to be paying close to 12 percent annual percentage rate (APR) for any balances you roll over. On average, rewards credit cards charge well over 15 percent. And store cards are a nightmare, usually milking you to the tune of 25-30 percent APR. Even if you have a mainstream personal loan from your bank, keeping up payments can become a burden.
At the time of writing, if you have good credit and plenty of equity (the amount by which the current market value of your home exceeds the current balance on your mortgage), you might easily qualify for a refinance rate well below 4 percent. That could slash your interest costs. But, because you're likely to be spreading your payments over a much longer period, it could reduce your monthly debt payments even more.
2. When You're Worried About Your Credit Score
When you have too much expensive debt, it's easy to find your outgoings spiraling out of control. And, as you increasingly struggle to juggle monthly payments, the threat to your credit score increases both from dropped balls in the form of late or skipped payments and from ballooning balances on credit cards.
If you've been browsing online articles about refinancing, you may have come across one that warns about the harm to your credit score that a new mortgage can pose. There's a bit of truth in that, because there's a small penalty for credit inquiries and for newly opened accounts. But those are tiny, and – providing the new account is managed well – should fade away within months. The criteria that seriously impact your score are:
- Late and skipped payments (35 percent of your score is determined by your payment history, according to FICO)
- Using too big a proportion of your credit card limits (determines 30 percent of your score)
If you're worried you might be unable to maintain a perfect payment record on all your accounts or that you're going to run up card balances in excess of 30 percent of your credit limits, you should look at alternative ways of structuring your debt. And you can monitor your score and get hints on improving it by signing up for the LendingTree credit score service, which is entirely free.
3. When You Have an Unavoidable Major Expense
In an ideal world, you save up for major expenses. But few people live in an ideal world, and many find it hard enough to maintain a worthwhile emergency fund, let alone put away thousands for special life events.
For example, how many have $32,641 available? Yet that was the average cost nationwide of a wedding in 2015, according to wedding planning website TheKnot.com. If you wanted to wed in Manhattan, that average was $82,299.
Are weddings, helping kids with college fees, fixing the roof on your house or expanding your business "unavoidable" major expenses? That depends on your personal circumstances and priorities. But if you feel you have to find chunky sums of money in a hurry, then a cash-out refinance should be on your list of possible sources.
4. When You're Investing Wisely
Borrowing to invest in stocks or businesses is a risky strategy: There's no such thing as 100-percent safe investment. And those that are close (U.S. Treasury bonds, perhaps) don't give a high enough return to cover the cost of borrowing.
But some home improvements can pay for themselves over time and provide you with a nicer living environment while they do. Few would criticize you for refinancing to pay for those, providing you first make sure the work you do will likely make a return on your investment.
A cash-out refinance is a big step financially, and it's important you go into it with your eyes wide open. So consider the pros and cons and the impact of the one you're planning on your wider situation. Don't forget:
- Most debt, including credit card balances, are "unsecured", meaning you're less likely to lose your home if you default. Mortgages are "secured," so your home is at risk if you get into trouble.
- Your refinancing might affect your overall financial strategy. Learn more at Refinance Your Mortgage Without Hurting Your Net Worth.
- Your refinance might be tax efficient. They usually are.
- There may be better alternatives in your particular situation, such as a home equity loan or home equity line of credit.
- Debt consolidation can be advantageous, providing it doesn't turn into a habit. Read How to Make Sure This Is Your Last Debt Consolidation.