Housing experts’ forecasts are coming true: mortgage rates are going up in 2022, having just hit their highest peak since March 2020. Homeowners interested in cashing out their home equity through a cash-out refinance might be tempted to move quickly — before rates rise even more.
While just months ago it seemed like the ideal time to refinance your mortgage, the upward trend of interest rates indicates you should probably crunch numbers more carefully in 2022. Otherwise, you might not break even on your refinance and pay more over the lifetime of your mortgage than you’d like.
Home valuations are still high, so in that sense, it’s still a somewhat favorable time to tap into your increased home equity with a cash-out refinance. But on the other hand, refinancing activity has slowed by 7%, according to a recent Mortgage Bankers Association (MBA) report, suggesting that rising interest rates have already begun to disincentivize refinancing applications.
Like all real estate transactions, cash-out refinancing is all about timing. Recent trends suggest the ideal refinancing window is coming to a close. However, every situation is unique. Despite the recent interest rate increases, mortgage rates are still near historic lows. In other words, it’s all relative.
Let’s have a look at your cash-out refinancing options and explore the pros and cons of doing a cash-out refinance in today’s market.
How Does a Cash-Out Refinance Work?
A cash-out refinance is a tool that allows you to extract cash value from your home equity. Like a rate-and-term refinance, you take out a new mortgage and use it to pay off your old one. The difference is, your new mortgage will be for a larger amount than what you originally owed, thus reducing your equity in your home but letting you pocket the difference as cash.
Home equity represents how much of your home you actually own, and is calculated by dividing your current mortgage balance by your home’s market value. You can gain home equity in two ways: when your mortgage balance goes down as you make payments, or when your home’s market value rises due to market conditions. Right now, with high demand and low inventory driving home prices up nationwide, many homeowners have found themselves with increased home equity without needing to do anything.
“If you have established equity, it’s like a savings account you’ve established,” says Vicki Ide, vice president and residential lending manager at Tompkins VIST Bank. You can then tap into that equity for instant cash through a cash-out refinance, home equity loan, or HELOC.
Typically, lenders will allow for a maximum loan-to-value (LTV) ratio of 80%, meaning you need to keep at least 20% equity in your home. For example: If your home is worth $500,000 and the remaining balance on your mortgage is $200,000, you have $300,000 equity in your home. You could do a cash-out refinance and replace your current mortgage with one worth $400,000, letting you keep $100,000 of equity in your home and walk away with a $200,000 check.
However, this lump sum of cash isn’t free. In some ways, a cash-out refinance is like starting a whole new mortgage over again — with new terms, closing costs, and interest rates determined by both the market and your credit profile. Financing a new, larger mortgage will likely result in higher monthly payments and an increased amount of time to pay off the loan.
Why Get a Cash-Out Refinance?
One of the biggest advantages of a cash-out refinance is the opportunity to use the cash to pay off other forms of debt — like credit cards or personal loans — that have high or variable interest rates. For instance, if you have a balance of $10,000 on a credit card that charges 20.99% APR and a $20,000 personal loan that charges 13.99% APR, it makes sense to take advantage of today’s relatively low refi rates and pay off that debt. Even at their highest, mortgage rates tend to be low compared to interest rates on other credit products, especially for borrowers with good credit who shop around with multiple lenders to get the best deal.
Before you do a cash-out refinance, make sure to have a budget and a plan for what you will do with your equity. If you plan to pay off credit cards or other high-interest debt, plan ahead to avoid overcharging on your cards again once the balance is gone.
“Eliminating that interest rate risk can make a lot of sense,” says Devin Pope, partner and senior wealth advisor at Albion Financial Group.
However, being credit card debt-free can also be a double-edged sword, Pope says. Too often, borrowers who do a cash-out refi turn around and rack up credit card debt again, putting them in a worse position than before. Make sure you’re not using a cash-out refinance to cover up bad spending habits that could hurt you again in the future.
“If you’re in debt, it probably makes sense to evaluate your budget first before you look at a cash-out refinance,” says Pope.
Pros and Cons of Cash-Out Refinancing
When deciding if a cash-out refinance is a good idea for your situation right now, consider the following pros and cons:
Lower interest rate than other forms of debt
Affordable way to access home equity
Can help you pay off credit card or personal loan debt
Stable, fixed monthly payment
Increases your overall debt load
Resets the term of your mortgage
Can enable bad financial habits
Involves closing costs for the new mortgage
Cash-Out Refinancing vs. Home Equity Loans
All three of these options have the same primary benefit: Low interest rates compared to other forms of debt. The major difference between these options is how they affect your primary mortgage. With a cash-out refinance, the mortgage is paid off and a new (larger) one is created, which resets the clock on your mortgage. For home equity lending, your original mortgage stays intact, and the home equity loan is applied on top of it.
Home equity loans are similar to a cash-out refinance in that they give you access to a lump sum of cash upfront, which is then typically paid back over a 20- to 30-year period. Meanwhile, a home equity line of credit functions more like a credit card: You can use as much as you want, whenever you want, up to a certain limit for a certain period of time, and only have to pay back what you use.
If you’re trying to decide between these options, Pope suggests thinking about your timeline.
“I like home equity loans for more short-term, bridge financing,” Pope says. Think of a home renovation that you plan to pay off in a year or two. The interest rates for home equity lending may be higher than a cash-out refinance, but they typically have less closing costs than a mortgage or refinance. This option can make sense if you plan to pay off the loan quickly.
On the other hand, if you’re working on a longer timeline — say, consolidating a large chunk of debt that you want to spread out over a 30-year mortgage term — a cash-out refinance could make more sense, Pope says, because it allows you to lock in that low interest rate and lower monthly payment.
Cash-Out Refinancing with Rising Interest Rates
It’s no secret that the pandemic-era stretch of historically low interest rates is coming to an end. Mortgage rates have already started to increase — even faster than some experts predicted — and are likely to only go higher from here.
That’s an important fact when you’re considering a cash-out refinance, because it would reset your mortgage with a new interest rate — one that could be higher than what you have currently.
“The lower [rates] are, the easier it is to make the decision to refinance,” says Pope.
Right now, rates are still relatively low. The average 30-year fixed refinance rate at the time of writing is 4.01%, and the average 15-year fixed refinance rate is even lower, at 3.36%. Of course, these rates are slightly higher than the all-time lows back in December 2020 (around 3.0%), but they are well below the average rates for credit cards, personal loans, and student loans.
“I still think [refinancing is] an attractive option,” Pope says, especially if your original mortgage rate is significantly higher.
However, the math could change in the next few months, says Ide. “As that margin slims … that minimizes the amount of people that are considering cash-outs,” she says.
As interest rates continue to creep up, refinancing becomes a more costly venture. High rates mean higher monthly payments. If you bought or refinanced your home at the beginning of the pandemic, you might now have the increased equity to consider a cash-out refinance, but doing so would mean forfeiting a historically low interest rate.
But experts agree by and large that it’s still a smart time to refinance if you really need to. The sooner you do so, the better interest rate you’ll likely get.
“Rates are still low in my opinion,” Ide says. “I still think it’s cheap money if you need it.”
Is a Cash-Out Refinance Worth It for My Situation?
Deciding whether to pursue a cash-out refinance largely comes down to your reason for doing it.
“Debt can be a good tool as part of your overall financial plan if used correctly,” says Pope. Consumers should ask why they need the money and whether the purpose is worth the potential increase in monthly mortgage payments and lifetime interest.
The choice is ultimately up to every individual consumer, but high-interest debt consolidation and home renovations are two commonly accepted investments that justify getting a cash-out refinance, Pope says. That argument is particularly strong when any home renovations increase the resale value of a home, although personal satisfaction is also a valid reason if the costs are acceptable to you.
“It’s just one of those tools in your belt,” Ide says. “If you have a need and you have the ability, it’s definitely worth looking into.”