Homeowners have long used a financial tool to address their cash-flow woes: their home equity. The equity represents the market value of the property above the mortgage balance. With a home-equity loan, you can access the equity you've built up to meet emergency expenses, pay off some credit cards or arrange for home improvements. If interest rates fall, you can refinance the home-equity loan and, as a bonus, take some of the equity out as cash.
Refinancing any loan only makes sense if interest rates drop and you have a chance to lower your monthly interest payments. Lenders don't work for free, and because the refinancing process is going to involve various fees and expenses, you might run the numbers and discover that the deal is not worth the cost unless you stay in the home for a while. For example, if your refinance costs are $3,000, and your interest payments fall by $100 a month (the principle amount stays the same), you don't come out ahead until you've made 30 monthly payments.
The term "cash out" usually applies to a refinance of your first mortgage. If you change the terms of an existing mortgage, you can also elect to draw on the home equity in the form of cash. At the closing, the lender presents you with a check -- while your mortgage balance increases. In a refinance of a home-equity loan, you can do the same thing: Simply access any equity left by applying for a cash payment. Again, the loan principle amount will increase, and your equity will decrease.
Borrowing more cash against your home equity adds to your debt and might only be a sound financial choice if you are using the cash for emergency expenses or to pay down other higher-interest debts. This would include most credit cards, payday loans, bank credit lines and installment loans on things like appliances, electronics and furniture. And if you already have a home-equity line of credit, you can access equity in the form of cash by simply writing a check, so refinancing and its associated costs are not really necessary. If you've maxed out the equity already, then a cash-out refinance is not going to be an option.
Consider the repayment terms of any refinance, whether it's first mortgage or home-equity line. You could be faced with a balloon payment, or a higher monthly payment if you've rolled some cashed-out equity into the new loan. A higher monthly payment is going to hurt unless your income has also increased; that's why the only good reason for a cash-out refinance is to get other installment loans paid off. And if the value of your home falls, any equity you have left is going to diminish as well, potentially leaving you upside down -- owing more in home loans than the property is worth.
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