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Cash Out Refinancing: How It Works

Cash-out refinancing involves taking out a new mortgage that has 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.

This option only works when you have equity in your home. (Home equity is the part of the home that you actually own. For example, if your home is worth $250,000 and you still owe $200,000 on the mortgage, the difference is the equity available to you: $50,000 in this case. In general, that $50,000 is available for you to use, although the actual amount can depend on your lender.)

Debt consolidation

Say you have $50,000 in credit card debt and you are paying an 18 percent interest rate. You can get an interest rate at a fraction of that by using your home as collateral. With cash-out refinancing, you can increase your principal by $50,000. At closing, you get that $50,000 to use however you want. You can then pay off your credit card debts immediately. If you do that, the debt is then wrapped up into your mortgage, but that can be advantageous to you. Instead of paying an 18 percent interest rate that is not tax deductible, your new loan will have a much lower rate at probably somewhere around 6 percent -- and you are likely to get tax benefits since the debt is tied to your mortgage.

If you are considering cash-out refinancing, make sure you are aware of the potential pitfalls. Even though cash-out refinancing can be a great way to pay off debt, it can also be a foolish move if you do not curtail your spending. Cash-out refinancing does not help if you continue to run up credit card debt. If you acquire more debt, you only succeed in having a larger debt on your mortgage in addition to even more credit card debt.

Cash-out refinancing only makes sense if you couple it with financial restraint. Also keep in mind that the debt will now be tied to your mortgage, making it possible for you to lose your home if you fail to repay the debt.

Although cash-out refinancing should not be entered into lightly, it is a good option to get out of credit card debt and pay less interest if you make the move with caution.

Example

Cash-out refinancing is a popular way of freeing up cash to put toward a major purchase, such as a home renovation or new vehicle. It involves refinancing your mortgage for more than you currently owe and "cashing out" the difference. Whether that results in a higher monthly payment is up to you.

It's possible to cash out some of the equity you've built up in your home if you've been paying down your mortgage for some time and the principal has shrunk to less than it was when you first took out the mortgage. This buildup of equity enables you to request to withdraw funds when you refinance. The amount you withdraw is simply added back onto your mortgage principal.

Let's consider an example. Imagine that your home is valued at $200,000 and that you have a 7 percent fixed-rate mortgage with a 15-year term. You've been paying $1,400 a month for five years, and your principal is down to $120,000 with 10 years to go before it's paid off. That means that your equity in the home is now $80,000 ($200,000 minus the $120,000 you still owe).

Now imagine you have an opportunity to refinance at 6 percent, and you'd also like to cash out $30,000 of your equity to put in a swimming pool. That would increase your mortgage principal to $150,000 (the $120,000 you still owe plus the $30,000 you take out) and reduce your equity to $50,000.

You now have a choice about how you want to pay your loan back. If you want to continue making roughly the same monthly payment as before, it will take longer to pay off the loan, since the principal is now higher. On the other hand, if you want to stick to your original schedule, you will have to increase your monthly payments.

How does the math work out? In our example, to pay off your loan in 10 years your monthly payment would need to increase to $1,665. If you were to keep paying $1,400 a month, the new loan would take 12 years and nine months to pay off. And, because lenders don't typically offer 12-year mortgages, in reality, the closest you could get would likely be a 15-year term. This would mean your monthly payment would actually fall to $1,265.

The choice is up to you. But keep in mind that the longer you take to pay off your loan, the more interest you will have to pay. In this example, taking an extra five years to pay off the loan would cost around $28,000 extra in interest payments. As a general rule, provided you can afford it, it's therefore usually better to pay a little more each month and pay your loan off faster.

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