Cash-out refinances generally increase during a housing bull market. However, if the real estate market declines, those who cashed out will find their home equity squeezed further.
What Is A Cash-Out Refinance?
A cash-out refinance lets a property owner to use their home mortgage to get additional cash. This mortgage refinancing option replaces an existing mortgage with a new, larger mortgage. The difference between the old and new mortgage amount is paid to the borrower as cash.
What's the catch? A cash-in refinance typically comes with a higher interest rate or more points. Getting a standard “rate-and-term” refinance for the same amount usually has better terms.
The amount you can receive from a cash-out refinance is determined by several factors. The most common determinants are your credit score, the property's LTV ratio (loan-to-value), and your bank's lending standards.
Having lots of cash buys you lots of alcohol, access, and action – Triple AAA if you will. What more does anybody want? With lots of cash, you can also try and buy another investment property.
The Temptation Of Cheap Money Is Strong
Triple AAA tempted me before. I considered doing a cash-out refinance for one of my rental properties at a mortgage rate of 3.375%. If you're in a oppressively high federal income tax bracket, you might consider doing a cash-out refinance. It may lower your income tax bill.
I'm pretty sure I'll be in a lower income tax bracket during retirement (as will you most likely). Thus, I figure why not extract cash out of a rental property. This can increase my interest expense to shield my rental income. With 5-year rental property money at only 3.375%, it would be foolish not to at least consider the option.
The rental market was very strong when I was considering doing a cash-out refinance. As a result, I was able to increase my asking rent price by 12% last month from a year ago. My realtor friends implored me to raise the rent by another couple hundred bucks. But, I didn't have the heart. I had already put the price out there on Craigslist, and I found a potentially ideal tenant.
By refinancing, the cash flow for the rental property increased by another 23% for a total increase of 35%. Yet, despite this increased cash-flow, I thought long and hard whether increasing my debt to then negate my cash flow increase was the right financial decision in this low interest rate environment.
Doing a cash-out refinance is definitely something to consider if you have a hefty amount of equity in your property. Today, this is called your tappable equity, a new term that has started becoming more popular.
How To Decide Whether To Do A Cash-Out Refinance
1) What are you going to do with the money?
If you have no good plans for the money that will return at least the cost of your mortgage, then you probably shouldn't cash-out. CD and savings rates are still much lower than your mortgage rates, so you will be losing money every month you don't put it to good use.
Nothing is a guaranteed return, so think long and hard before plopping that cash down on something that sounds so good. That said, Treasury bonds are yielding 5% after the pandemic, which is a great risk-free return.
2) What's your outlook on the property market?
If you think the markets are going to tank 90%, then by all means cash out! You don't want to see your equity disappear. If you can legally cash out and have free cash in your bank account, then please do so before it disappears.
In the event of a housing market crash, it is then up to you to decide whether you should pay your mortgage or not. You should if you live in a recourse state, and maybe not if you live in a non-recourse state. Just don't brag about it and try and profiteer if you do welch on your debt!
3) How disciplined are you with money?
Some people go crazy irresponsible when they have a sudden influx of cash. If you are making say $100,000 a year with $50,000 in savings, could you handle an extra $200,000 in the bank after a cash-out refinance? Would you not be tempted to go on some fancy vacation or buy a car you've always wanted?
If so, then you shouldn't do a cash-out refi since you wouldn't have spent that money if you didn't get the injection. I have a weakness for nice vacations and cars, even though I haven't bought one in 4 years and drive a beater.
4) How much money are you making?
If you already have a high amount of cash-flow or have a a healthy year-end bonus every year and don't plan to get fired, then perhaps you really shouldn't do a cash-out refinance. For example, let's say you want to cash-out $100,000, but you can save $100,000 every year. If this is the case, why bother?
5) Understand the rate differential.
My banker said I could do a cash-out refinance if I wanted to, but then said my mortgage would have to be re-underwritten, and the rate would go up. Funny how they didn't tell me this before my appraisal. I was thinking to myself if I borrow more money, I could get a lower rate! Silly me. It's quite the opposite. This higher rate was the straw that broke the camels back as he tried a little bait and switch. I'm a rate seeker.
6 How desperate are you for cash?
The more desperate you are for liquidity, the more it makes sense to do a cash-out refinance. Your house is likely your largest asset, which isn't doing you much good except for providing you a hopefully rent-free place to live. Hence, if you can extra cash from your house, particularly if you are house rich cash poor, then a cash-out refinance may make sense.
If you are at the point where you have to sell precious belongings, priceless memorabilia, and liquidating your grandchildren's education funds, then doing a cash-out refinance is a much better option.
Doing A Cash-Out Refinance Is OK If You Are Disciplined
Cash-out refinancing is just accounting. You either have cash in the bank or equity in the house. I would actually much rather have cash in hand to do what I want (invest, spend, remodel, travel) than have it stuck in a house which might burn down.
Housing will continue to get better over the next 5-10 years. Just make sure that if you do a cash-out refinance that you spend it wisely, preferably on living a better life and investing for more security.
Related post: During Times Of Uncertainty, Take Stock Of ALL Your Cash
Real Estate Recommendations
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To Cash-Out Refinance Or Not is a Financial Samurai original post. In general, I recommend not cashing out and trying to keep paying down the mortgage. You'll be glad you did in the future.