Cash-out refinancing: Unlock your loan's equity

Imagine that you just noticed water leaking from your ceiling and the roofing company tells you that you need to replace your entire roof. Or it’s 110 degrees on a sweltering summer day and your AC goes out — again — and your trusted AC company says that your system was on its last leg and that leg just gave out. Or maybe you aren’t dealing with an emergency but instead have finally decided to install the new pool or kitchen upgrades you’ve been dreaming of.

If you don’t have cash on hand to pay for these expenses, what would you do? Well, in some cases, you might consider cash-out refinancing. Let’s explore it.

What is cash-out refinancing?

When you cash-out refinance, you are replacing your current loan with a larger one. You use the money from the new loan to pay off your first loan, and then you have available funds remaining to use as you wish. You can cash-out refinance multiple types of loans, from personal loans to auto loans to mortgages.

How does cash-out refinancing work?

How cash-out refinancing works varies based on the type of loan you are refinancing. Let’s look at a couple of the most popular ones.

Personal loan

Let’s say you have a $6,000 personal loan that you’ve paid down to $3,000. If you refinance the loan for $10,000, $3,000 goes to pay off the original loan and you have $7,000 available for your needs.

But you may have the same question I did when I was first learning about cash-out refinance of a personal loan: Why not just get a new loan instead of refinancing the current one? It seems like the outcome is the same, and in a way it is. But the lender’s consideration of your debt-to-income ratio is one of the differences. To explain this, let’s look at the example again from two different perspectives.

Let’s say you are in the situation above and are applying for a new $10,000 loan. To the lender, it will look like you have $3,000 remaining on a loan and are also applying for a $10K loan. That means your total debt would be $13,000. But if you refinance your original $6,000 loan, to the lender, it will look like you are only applying for a $10,000 loan, so you’re only going into $10,000 in debt.

Why is this different? If you have a high debt-to-income ratio, which might not be favorable for lenders, you might qualify for a refinance even if you would not qualify for a new loan. They might approve you for $10,000 of debt, but $13,000 is too much.

In a refinance, the lender knows that the original loan will be paid off. If you get a new loan, there is no guarantee that it will be. This is increased risk for the lender.

Tapping into home equity

Why would I tap into my home equity? For most people, their home is their biggest asset, both in terms of physical size and value. And home equity financing can have potential tax advantages and typically carries lower interest rates than credit cards or personal loans.

For example, Bankrate reports that in March 2024, the average personal loan rate was 12.10%, but the average rate for a home equity line of credit (HELOC) is 8.98%. That’s significant savings.

And, depending on the size of your project, you may be able to get more cash by tapping into your home equity than you can get through a personal loan. For example, a personal loan might top out at $100,000 but depending on your home value, you might be able to get a home equity loan valued at $200,000 or $300,000.

On the downside, tapping into your home’s equity means you’re putting your home at risk. It’s important to have a roof over your head, so think about that before putting your home up as collateral.

Home equity line of credit (HELOC)

A HELOC is a line of credit against your home’s equity, it’s not a new mortgage. But, just like a mortgage, the collateral on a HELOC is your home. You’re pre-approved for a certain spending limit and you’re able to use the funds as needed. You’re charged interest only on your outstanding balance and not the entire credit line.

Often, lenders will place limits on how much you can borrow, usually about 85% of your home’s value. Here’s how that works. Let’s say your home is valued at $200,000. Therefore, you could borrow up to 85% of that amount minus the outstanding balance of your mortgage.

If your mortgage has an outstanding balance of $100,000, then you could borrow up to $70,000 — 85% of $200,000 is $170,000, then subtract the $100,000 you still owe on your mortgage, and you get $70,000.

Home equity loan

You can also get a home equity loan, which is similar to a HELOC in that you are borrowing against your home’s equity. But a home equity loan is a one-time loan, not a recurring line of credit. This highlights one downside of a home equity loan: You need to decide how much you need up front.

Let’s say that you took out a $25,000 home equity loan for a pool but due to unforeseen plumbing issues, the pool actually costs $30,000. Where will you get that extra $5,000? Pulling it from savings or getting a $5,000 personal loan might be the answer if you can qualify for one. However, if you have a HELOC with access up to $50,000, for example, you could easily account for overages and only use what you need.

The reverse is also true. What if you get a home equity loan worth $30,000 for a pool and it only costs $20,000. You essentially have overborrowed by $10,000 and are paying interest on money you might not need. Now, you could pay off the loan early or use the extra funds for other purposes, such as paying down high-interest debt or making other home improvements.

Cash-out refinance of a mortgage

This is much like a cash-out refinance of a personal loan, except it’s for a mortgage. You are getting a new larger mortgage, using it to pay off your current mortgage, and keeping the difference to use as you wish — minus any fees, of course.

All these options can be a good way to tap into your home’s equity, you just need to decide which one is best for you based on what’s available to you. To help you make your decision, ask yourself these questions:

• Are there fees involved and, if so, will they offset any benefits you’ll receive? Some examples of fees can be closing costs, appraisal fees, or origination fees.
• Will this be a variable or fixed interest rate? This is important because if it’s a variable interest rate, and the interest rate adjusts up, it might make the payment unaffordable.
  
  

Is a cash-out refinancing a good idea?

As with many financial questions, the answer is that it depends. It depends on the current interest environment, your current financial situation, and the different options available to you. Faced with the same scenario, each person might come to a different answer to that question. That’s why it’s important to analyze your options before deciding.

Here are some factors to consider before doing a cash-out refinance or a home equity loan.

Interest rates

What if interest rates are higher?

You might assume higher interest rates would be a negative and while it is, in some circumstances, it can still work to your advantage. For example, it might make sense when you can’t afford the payments on your original loan and need to extend the loan time frame.

Let’s say you borrowed $10,000 for 36 months at a 10.19% interest rate and have a monthly payment of $323.56. What if you only have $8,000 left of that loan but you can no longer afford the payments?

If you refinance the $8,000 to a 48-month loan with an 11.44% interest rate, your loan payment drops to $208.48 per month — even with the higher interest rate. But in this scenario, you’re not increasing the amount of your loan or your debt. You’re not doing a cash-out refinance, just a regular refinance.

But what if you’re doing a cash-out refinance? This next example highlights how it might not be to your advantage to do a cash-out refinance when interest rates are higher.

Let’s use the same situation but adding the fact that you need $5,000 for some home repairs. You decide to do a cash-out refinance of your personal loan for $13,000 at 11.44%. Your new payment would be $338.78, $15 more than it was before. If it was unaffordable before, it’ll be unaffordable now.

Even if you’re in a situation where you can afford this new increased payment, is this the best way to achieve your financial goal?

What if interest rates are lower?

In this case, you need to do the math. With a lower or the same interest rate, it might be possible to refinance, keep the payment the same, and get some cash for an immediate need. Or, depending on the terms of the new loan, you might be able to lower your monthly payment, which can help you pay off your debt faster. But be careful that loan fees don’t cost you more than you’re saving.

How much interest will I pay over the life of the loan?

Even if you change the loan terms to make it affordable, it’s important to understand how much you will be paying in total interest charges, as that affects your ability to achieve other financial goals. Let’s look at two $10,000 loans, one for 36 months and one for 48 months, both at a 10.19% interest rate.

• 36-month loan: Monthly payment of $323.56 and total interest paid is $1,648.33
• 48-month loan: Monthly payment of $254.54 and total interest paid is $2,217.89

If you are in the situation where you can’t afford the 36-month payment and choose to go with a 48-month loan, you need to understand that you are paying $569.56 more in interest. What could you do with this money if you weren’t paying it in interest? You could increase your financial security by increasing your emergency fund savings account. Or, you could add it to your next vehicle down payment.

On a side note, this is the same tactic used by car dealerships to get you to purchase a higher-priced vehicle. You’re looking for a 48-month loan, but you can’t afford this payment on the vehicle they’re encouraging you to purchase. So, they suggest an 84-month loan to get the numbers to work. What they don’t tell you is how much more this vehicle will cost you in the long term.

For example: If you get a $40,000 loan for 48 months at 6.5% APR, you will pay $5,532.71 in interest over the life of the loan. If you do this same $40,000 loan but pay it over 84 months, you will pay $9,894.11 in interest charges, or $4,361.40 more. That’s a substantial difference. A longer loan might be an indicator that you are buying more car than you can afford, which can come with additional risks. Learn more about how long your car loan should be.

Are there prepayment penalties?

One particularly important loan term to watch out for is a prepayment penalty. That’s an additional fee charged by the lender if you pay off the loan early. You want to avoid these loans because everyone’s goal should be to pay off their loan early. Most lenders don’t have prepayment penalties, and USAA Bank doesn’t either. But always verify this before getting the loan.

Uses for cash-out refinancing

The sky is truly the limit on the uses of a cash-out refinance. You can use the money to pay down debt, make home improvements, or help with other major expenses like replacing the AC or roof of your home. Let’s look at one common example to illustrate the value.

Cash out to pay off debt

Let’s say you have these two sources of debt:

• $10,000 of credit card debt at 20% interest rate
• $5,000 left on a $10,000 personal loan at 10.19% interest rate

You consolidate debt by doing a cash-out refinance of the personal loan for a value of $15,000 and use it to pay off the credit card debt. Of the refinanced personal loan, $5,000 pays off the old loan and $10,000 pays off the credit card. As long as the interest rates are similar, you will be saving money because you won’t be paying 20% interest on the $10,000 credit card balance. That can be a great use of a cash-out refinance.

And not only can it save you money, but it can also help simplify payments. Once the credit card is paid off, you only have one debt to pay instead of two. Just make sure you don’t run the credit card back up and get into an even worse situation, where you’d have credit card debt again and an even higher personal loan.

Cash-out refinancing of a loan vs. a mortgage

So how do you decide between the different types of loans or refinances that might be available to you, as many of them might fit your need? Let’s look at some pros and cons of the different types of loans.

Personal loan

Pros:

• It can be quick and relatively easy to get.
• It usually has minimal to zero fees.

Cons:

• It might be at a higher interest rate than other types of loans.
• It’s not tax deductible.

HELOC

Pros:

• You might be able to get a lower interest rate than other types of loan.
• Interest may be tax deductible if it meets IRS guidelines.
• Since it’s a line of credit, you can only borrow what you need, when you need it.
• It can be for higher dollar amounts than you might be able to get with a personal loan, which can be good for large home improvement projects.

Cons:

• You’ll typically pay fees, but less than what you would find for a home equity loan.
• Because a HELOC is tied to your home equity, the lender can reduce, freeze, or cancel your line of credit.
• It’s usually at a variable interest rate, which can cause problems if interest rates increase.
• If you don't pay back the borrowed amount, your home is at risk of foreclosure.

Home equity loan or cash-out refinance of a mortgage

Pros:

• It can be at a lower interest rate than other types of loan.
• Interest may be tax deductible if it meets IRS guidelines.
• It can be for higher dollar amounts than you might be able to get with a personal loan, which can be good for large home improvement projects.
• A fixed interest rate makes repayment predictable.

Cons:

• You might pay fees such as closing costs, which can be 2% to 5% of the value of the loan.
• It has limited flexibility as this is a one-time loan, but you must decide how much you need up front.
• If you can't make your payments, your home is at risk of foreclosure.

If you think one of these loan options can benefit you, check out USAA Bank’s home loan and refinance options.

Even with all these loan options, your best bet might be to avoid loans altogether — when possible. You can do this by having a fully funded emergency fund or taking time to save up for larger home improvement projects. But this isn’t always feasible.

When you have a need, take time to consider all your alternatives, shop around, and make the decision that helps you get back on track financially. Then, do your best to pay off any debt as quickly as possible and get back to focusing on your other financial goals.