I maintain that the best use of a cash-out refinance is to improve the value of your home. However, not all home improvements are created equal; you need to put the money into the projects that will return the most value. Be sure to mind due diligence and use a cash-out refinance for home improvements that will result in the highest return on investment; only then can I recommend such a strategy.
A cash-out refinance for home improvements can be a great move under the right circumstances, which begs the questions: What is a cash-out refinance?
Put simply, a cash-out refinance is a way for homeowners to refinance their current mortgage for more than the outstanding balance and keep the difference. The difference between the old loan and the new loan is essentially equity that you may draw upon. For instance, if you wanted $25,000 to make improvements to your home, you can refinance the mortgage you currently have for $25,000 more than its remaining balance. In other words, if you still owe $100,000 on your mortgage, you can refinance for $125,000 and use the $25,000 you pulled out to make the appropriate home improvements. What’s more, it’s entirely possible to refinance under a lower interest rate.
I want to make it abundantly clear: a cash-out refinance for home improvements can be a great idea. In the event you are able to increase the value of your home, such a move could pay huge dividends. However, cash-out refinances aren’t without their own caveats. The same process got a lot of people in trouble when the downturn occurred just over a decade ago.
“It’s your house, and you have to be very careful with what you’re doing,” says Michael Moskowitz, founder and president at Equity Now, a New York-based mortgage lender. “For everyone who mortgaged their house to keep a business going, some made a fortune, but there were many people who lost their homes.”
It’s absolutely imperative that you weigh the pros and cons of using a cash-out refinance for home improvements before you decide to take the leap. Let’s take a look at some of the biggest pros and cons you need to pay special considerations to.
You can finance the home improvements
The best benefit of using a cash-out refinance for home improvements is also the most obvious: it allows you to fund larger expenses. And what are home improvements if not for larger than average expenses? More specifically, initiating a cash-out refinance for home improvements is another way to tap into the money you already have in a liquid asset. It’s worth noting, however, that if used correctly, said capital can very easily increase the resale value of your property. So while you not only detract from the equity you have managed to build up to a certain point and extend the term of the loan, you can very easily reinvest the money into the home to make it worth more. It’s also worth noting that those who choose the route of a cash-out refinance will probably be able to take advantage of a more attractive interest rate, which brings me to my next benefit.
You lower your interest rate
In the event you decide to use a cash-out refinance for home improvements, you must mind due diligence. For starters, I highly recommend shopping around for various lenders. Don’t hesitate to exhaust all of your resources and check everywhere from local lenders and credit unions to larger institutional lenders and even the bank you are currently with. In doing so, you could find lenders offering better interest rates and fewer fees. This could save you a lot of money over the life of the refinanced loan.
You increase your chances of going “underwater”
Not surprisingly, borrowing against the equity in your home places you at a greater risk of owing more than the home is worth. In the event values drop, you are at a greater risk of being stuck with an underwater mortgage. In fact, data uncovered by the Federal Reserve suggests that homeowners that follow through with a cash-out refinance are more likely to default than those that decided to go with a regular refinance.
According to Bankrate, “in the 2nd quarter of 2006, homeowners extracted $84 billion in home equity. Cash-out refis represented nearly 89% of all refinances in that quarter. That preceded an unprecedented nosedive in home prices, which eliminated more than half of Americans’ home equity to the tune of $6.73 trillion.”
It’s a lengthy and expensive process
As is the case when you are working with such large sums of money, a cash-out refinance for home improvements will coincide with a lengthy and sometimes pricey process. If you intend to go down this route, don’t expect it to be quick and painless. In fact, treat it like you would any other mortgage transaction. Expect to gather many of the same documents it took to get your first mortgage. It’s also worth noting that the average cash-out refinance will come complete with closing costs, which can run in excess of thousands of dollars in some cases.
Using a cash-out refinance for home improvements can be a great move, provided you are able to increase the value of your home. However, there are consequences, and you would be wise to know them before you even consider borrowing against the equity in your home.