The Pros and Cons of a Cash-Out Refinance

If you’re looking for extra cash to pay off or consolidate debt, fund home improvement projects, or start a business, you may have considered tapping into your home’s equity using a cash-out refinance.

This involves replacing your existing home mortgage with a new loan for a larger amount, which in turn allows you to pay off your existing loan and access additional funds for other needs or wants. Lenders typically allow you to access up to 80 or 85% of your home’s value through a cash-out refinance.

Refinancing your home mortgage is a major financial decision, though, so it is important to understand the pros and cons, as well as how doing so could impact other areas of your financial plan.

Cash-Out Refinance Pros and Cons

There are both advantages and drawbacks to doing a cash-out refinance. On the plus side, this strategy allows you access to money at a potentially lower interest rate, as compared to taking out a personal loan or borrowing cash from a credit card. In addition, if you itemize deductions on your income tax return, the interest you pay on the refinanced home loan may be tax deductible.

If you refinanced to a new loan with a fixed interest rate, you would also have predictable monthly payments, which can make budgeting easier. This is not necessarily the case with other cash-out alternatives like a home equity line of credit that oftentimes carries a variable interest rate.

There are other potential positives with a cash-out refinance, such as a possible increase in your credit score—especially if you used the funds from the refinance to consolidate higher-interest debts.

Yet, even given all the benefits of a cash-out refinance, there are some possible drawbacks to consider. For example, doing so can increase your debt obligations, while at the same time decreasing the equity you have in your home.

Further, “starting over” with a new home loan can also mean that you will be paying your mortgage for a longer period of time. So, you should consider your overall budget before moving forward—particularly if you are approaching retirement and trying to reduce your monthly expenses.

As with other types of home loans, a cash-out refinance can also be expensive, given that you will likely have to pay additional closing costs. Plus, you could be adding the risk of your home being foreclosed if you are unable to make the payments in the future.

Special Considerations for Texans

While cash-out refinancing is allowed in Texas, the state imposes different rules and guidelines than other states do. In Texas, a cash-out refinance is also referred to as a Section 50(a)(6) loan (or simply an A6 loan).

Texas-specific rules that pertain to cash-out refinancing include the following:

• The new loan amount may not exceed 80% of the value of your home. When you do a cash-out refinance in Texas, you must maintain at least 20% equity in the home.
• Closing costs may not exceed 2% of the new loan amount. However, this 2% cap does not apply to third-party closing costs, such as title insurance, attorney fees, or mortgage insurance premiums.
• All liens on the home (such as any second mortgages) must be paid off. If you currently have a HELOC or home-equity loan on your home, it must be repaid before moving forward with a cash-out refinance.
• Home equity loans or home equity lines of credit are not allowed. If you already have a cash-out refinance loan in place, you are not allowed to also take out a home equity loan or home equity line of credit (HELOC).
• There is a six-month waiting period after purchasing your home. In Texas, you are only eligible for a cash-out refinance if you have had your existing home mortgage for six months or longer. In addition, if you have already done a cash-out refinance, you may not do so again unless it has been one year or more since the last one.
• Cash-out refinanced loans are not backed by the federal government. This means that there are no VA or FHA cash-out refinance loans available in Texas.
• Minimum credit score and maximum debt-to-income ratio are also considered. In Texas, most lenders require borrowers to have a credit score of at least 620 or higher in order to move forward with a cash-out refinance. Further, cash-out refinance borrowers in Texas must have a maximum debt-to-income ratio of 43%.

It is important to note that the Texas-specific cash-out refinance rules only apply to your primary residence, and not to second homes or investment property.

Should You Consider a Refinance?

There are many factors to consider before you move forward with a cash-out refinance. These should include:

• Interest rate. If the new loan has a lower interest rate than your current mortgage, as well as the other debt(s) that you wish to consolidate or pay off, then a cash-out refinance may make sense.
• New payment amount. You should also consider the amount of the new loan payment, particularly if it is significantly higher than your current mortgage payment. Further, if the payment is lower than your current bill, consider how much longer you will have the new loan obligation and if the expense may hinder your living costs in retirement.
• Tax deductions. Possible income tax deductions should also be considered before moving forward with a cash-out refinance.
• Cash-out refinance alternatives. There are possible alternatives to a cash-out refinance that should be considered, too. These include a HELOC. A home equity loan provides a lump sum of cash, based on the current equity you have in your home (versus a full home refinancing). With a HELOC, you have access to a revolving credit line that allows you to borrow what you need and pay interest only on the amount that is borrowed.

Because everyone’s financial needs and objectives are different, a cash-out refinance may or may not be right for you. With that in mind, you should discuss your short-term and long-term plans with a financial planning professional who can help you look at all the angles and determine whether you should move forward.