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What is cash-out refinancing?

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Cash-out refinancing is a transaction in which a new mortgage is issued that is greater than the outstanding unpaid principal balance of the previous mortgage. Cash-out transactions allow homeowners to spend the equity they have accumulated in their homes. It differs from a home equity loan or line of credit in that it's a new mortgage, not a second loan against the equity in a home. Both cash-out refinancing and home equity loans provide vehicles for taking cash from the home's equity. Whether it makes more sense to refinance and take cash out or borrow using a home equity loan depends on your financial goals, the interest rates on the new loans, the interest rate on your existing mortgage, your marginal income tax rate and your ability to use the mortgage interest deduction on your income taxes. A good method for deciding is to look at the "weighted APRs" of the loan alternatives. "Weighting" the APRs is easy: You take the interest rate of each loan and multiply it by its portion of the total debt. Let's say a homeowner owes $100,000 on an existing mortgage and wants to spend $50,000 on renovations. If the homeowner takes out a $50,000 home equity loan or line of credit, the homeowner would owe a total of $150,000: two-thirds of it in the form of the original $100,000 mortgage, one-third of it from the new home equity debt. So to get the weighted APRs, you would multiply the rate of the $100,000 mortgage by two-thirds and the $50,000 equity loan by one-third. Choose the alternative that has the lowest weighted APR with payments that fit your budget. Because APRs include estimates of closing costs, this method adjusts for the differences in closing costs among the alternatives.

As an example, a cash-out refinancing gives you a lower monthly payment, but higher overall payments since the homeowner would be paying for 30 years. If the homeowner makes an additional principal payment of $250 each month on the refinancing alternative, the entire loan will be paid off in 2018 with total payments of $258,534.