As the 30-year fixed mortgage rate hit an historic low of 2.65%, existing homeowners who seek home improvements or pay off high interest credit card debt may want to take advantage of the rate environment and built-up equity in their home.
Homeowners often can use cash-out refinances, a type of refinancing in which you replace your existing mortgage with another and take out equity as cash. You can receive a new mortgage up to 80% of your home’s value.
“With rates that can be considered the lowest in recent history, tapping into your home’s equity can be a great option for finally making that needed home improvement project or paying for another venture,” said Michael Hamelburger, CEO of the Bottom Line Group, an expense reduction consulting firm.
How does a cash-out refinance work?
A cash-out refinance is a form of refinancing in which you take out a new loan that is larger than your previous one. The difference between your old and new, larger loan is the amount of cash you receive.
For instance, if you own a $500,000 home, but have only $300,000 in an outstanding mortgage, that means you have $200,000 in equity that you own outright. Let’s say you need $15,000 for a home repair. When you do a cash-out refinance, you secure a larger loan for $315,000 and use it to pay off the $300,000 left on the original mortgage and to pocket the extra $15,000 for improving your home.
The requirements for qualifying for a cash-out refinance will be higher than that of a traditional mortgage. This means you may need a higher credit score or own your home for more than a year. Taking a cash-out refinance also means it may take you longer to pay off your mortgage and to own your home free and clear, unless you pay more than your monthly payment.
Lenders have created stricter lending standards that may come as a hurdle to some Americans. Many lenders are even pushing minimum credit thresholds for credit cards from 580 to the mid 600’s.
When should you consider a cash-out refinance?
While the amount of tappable home equity in the U.S. is at a record high, only those who need the cash for home improvements or lowering debt should take advantage of low rates, experts advise.
“The reasons you could take out a cash-out refinance would be a planned capital improvement on your house,” said Bill Brancaccio, cofounder of Rightirement Wealth Partners. “This would allow the interest to remain tax-deductible.”
Another reason a homeowner may consider a cash-out refinance is if they are saddled with high interest credit card debt. As credit card debt totals $890 billion in the U.S, according to the most recent Federal Reserve’s report on household debt, and with average interest rates at 16.04%, many Americans would benefit from consolidating their debt.
“Let’s say you have a lot of equity in your home and your rate is 5%, and, for one reason or another, you have a credit card at 18% interest with a large balance,” Brancaccio said. “By rolling that debt you planned on paying into the mortgage, you can save a lot in interest and start over.”
When should you not use a cash-out refinance?
Avoid using your home equity for purchases that you can finance by other means at attractive interest rates, such as cars and college.
“Don’t do a cash-out refinance to buy a new car as auto lenders are already offering really low-interest rates, and with closing costs this would make this a poor decision,” Brancaccio said.
“Taking money that was already interest-free to add interest to it is a complete gamble.”
Another reason for not securing a cash-out refinance at this time is for your or your children’s college education. That’s because rates on federal student loans are at all-time low.
“I’m not a big fan of using a cash-out refinance for college education [since] the interest rate on federal student loans for year 2020-2021 is only 2.75%, which is probably lower than the rate you can get for a cashout,” said Leslie Beck, owner of Compass Wealth mManagement. “You are putting your home at risk for something that can be funded in many other ways.”
Read more information and tips in our Mortgage section