Cash Out Refinance: When It's a Great Idea (or Not)

Cash out refinancing means replacing your old mortgage with a bigger and better home loan and taking the difference in cash. The following situations are examples of how a cash out refinance can be used.

Cash Out Refinancing Offers Financial Solutions

Cash out refinancing can be a very cheap way to borrow, because loans secured by real property are among the least risky for lenders. Here are several ways to refinance with cash and improve your finances.

Home Improvements

Refinancing to fund home improvements can be a good investment. Replacing a roof or windows, installing new flooring and updating kitchens and baths are examples of projects that can increase home value. If you're considering a major remodeling project, contact a licensed real estate pro in your area to learn which types of improvements potentially add value to your home.

Remodeling magazine advises that most projects do not add 100 percent of their cost to the home's value, but some projects like entry or garage door replacement, adding a deck or an attic bedroom addition come very close. In addition, improvements can make your home more comfortable today and help you sell it faster tomorrow.

Big Ticket Purchases

A cash out refinance can fund large purchases like vehicles or college tuition and keep payments relatively low. For example, if you finance a $25,000 car over five years at a seven percent interest rate, the payment is $495. Borrow at 4.25 percent for 30 years, however, and you pay just $123 a month. However, there are a couple of considerations.

Most personal finance experts do not recommend financing a short-term asset, like a car you expect to keep for five years, with a loan that won't be paid off for 30 years. It costs more in the long run -- the total interest for the seven percent loan is $4,702 over five years, but at 4.25 percent over 30 years, it's $19,276! Review loan offers from auto finance lenders and dealerships and compare them to the cost of cash out refinancing.

Financing college education with cash out might make sense, depending on how it compares to the kind of student loans are available to you. You'll want to review available student loans, which don't require collateral, and see how they stack up against cash out mortgage refinancing.

Debt Consolidation

Using a cash out refinance to pay off high-cost credit card debt can be a good financial decision, or it can lead to more problems. How or if cash out refinancing can work for debt consolidation depends on how you handle you debt and why you overspent in the first place.

Refinancing to pay off credit card balances incurred because of an emergency or temporary period of unemployment resolves a one-time financial crisis, but paying off credit card balances arising from a "shop-til-you drop" lifestyle may not have a positive outcome unless you change your spending habits.

Cash out refinancing doesn't eliminate debt; it transfers multiple higher-interest debts to a mortgage balance at a lower interest rate. Studies have shown that about three-quarters of consumers who consolidate credit card debt this way end up giving in to the temptation of newly zeroed out credit card balances and run them back up, leaving borrowers worse off than before.

Cash Out Refinance: Short Term Gain, but Long Term Cost

The St. Louis branch of the Federal Reserve explains that cash out refinancing can have long term consequences based on the extended repayment term and variables such as the inflation rate and overall economic conditions. The Fed suggests that homeowners consider their retirement plans and anticipated retirement income as part of plans for cash out refinancing. The National Association of Realtors® advises homeowners to be confident in their ability to repay any home loan, as defaulting on a mortgage or refinance loan can lead to foreclosure.

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