Cash-Out Refinancing Made Simple

With every mortgage payment you pay after a home purchase, you invest more in your home equity. As a potential source of funds, some of this home equity may be exchanged for cash, either through a home equity loan, or in the form of cash-out refinancing.

What is Cash-Out Refinancing?

Cash-out refinancing involves a mortgage refinance for an amount larger than what you currently owe, and pocketing the difference. If you have been making mortgage payments for some time, your principal is likely to be substantially lower than what it was when you first made your home purchase.

This build-up of home equity will allow you to take out a home loan that covers what you currently owe--and then some. For example, say you owe $90,000 on a $180,000 house, and you want $30,000 to add a family room. You could refinance your mortgage for $120,000, and the bank will then hand over a check for the difference of $30,000.

Using Cash-Out Refinancing for Purchases

As a means to access substantial funding, it's hard to beat cash-out refinancing. The funds are distributed in a lump sum, and you can use it for just about anything. Homeowners frequently use cash-out refinancing to pay for major expenditures, such as:

College tuition
Debt consolidation
Emergency expenses
Home renovations like a new kitchen or bath
New vehicle purchase

What's more, you may be able to get a more favorable interest rate for this mortgage refinance than your original home purchase.

However, if the interest rate offered for your mortgage refinance is higher than your current rate, this probably isn't a sensible choice. A home equity loan or line of credit (HELOC) might be a better idea. Also, if you borrow more than 80 percent of your home's value, you may have to pay private mortgage insurance or pay a higher interest rate. This might also make a HELOC a better choice.

Cash-Out Refinancing vs. Home Equity Loans

Homeowners sometimes confuse cash-out refinancing and home equity loans, although they are quite different. Cash-out refinancing replaces your old loan with a new one. Home equity loans, on the other hand, are separate loans carried on top of existing mortgages. In other words, a mortgage refinance results in a new mortgage, rather than a second loan against the equity in your home.

A mortgage refinance usually makes sense only when there's been a drop in interest rates, and you'd like to lock in a new mortgage at a lower rate for a longer term than your existing mortgage. It can also benefit those who want to refinance their mortgages for a longer term to lower their monthly payments. In situations that necessitate a short-term cash infusion, home equity loans are often a better choice.