- Home equity is the difference between the loan balance and the property's value.
- A cash-out refinance taps into home equity.
- Cash-out refinances can have negative consequences.
Need Cash To Make Home Improvements or Pay For a Child's Education? Consider a Cash-Out Refinance!
Some Bills.com readers express confusion about cash-out refinances, including how they work, who qualifies, what the cash can be used for, the hidden pitfalls of cash-out refinances, tax implications of cash-out refinances, and cash-out costs. This article will help you understand the basics of a cash-out refinance without going into painful levels of detail. It includes links to more detailed Bills.com resources to help you learn more more. Let's start with the basics.
What is Home Equity?
Home equity is the difference between the property’s fair market value and the outstanding balance of all liens on the property. A home’s equity is "owned" by the person on the property’s title — in other words, the home owner. It is a value on a spreadsheet; intangible but measurable. Home equity is not kept in a bank account or held by a creditor.
Home equity can best be described using an example. Let's say you buy a house for $100,000 and pay $0 as a down payment. Years later, comparable houses in the immediate area sell for $110,000. The balance remaining on the loan is $75,000. The homeowner’s equity at that moment in time is $35,000. Now, fast-forward again in time and say the house is worth $200,000 and remaining loan balance is $10,000. The homeowner’s equity at that moment is $190,000.
The equity is theoretical. The equity does not exist anywhere but is an asset the homeowner can tap into. Let us return to our second example above and say the homeowner has a child who just completed college with $20,000 in student loan debt. The homeowner shops for a mortgage refinance and finds a bank willing to refinance the mortgage at an attractive rate and is willing to give the homeowner $30,000 in cash. The refinance retires the original loan, which had a remaining balance of $10,000, and replaces it with a new $40,000 mortgage. The homeowner gives the child a $20,000 gift to retire the student loan debt and uses the remainder to remodel the home’s kitchen, retire a vehicle loan, take a cruise, or buy a boat. The homeowner decreased his or her equity by $30,000 from $190,000 to $160,000.
The homeowner could have refinanced with the original mortgage company. However, the homeowner is under no obligation to do so.
What Can a Mortgage Cash-Out Refinance Be Used For?
As mentioned above, the cash from a mortgage cash-out refinance can be used for positive or negative reasons. A positive reason saves the homeowner money, or frees-up the equity to put it to work. Here are four positive reasons for a mortgage cash-out refinance:
- Pay-off or avoid a student loan
- Pay-off a higher-interest debt, such as a credit-card debt
- Free capital for down payments to purchase more property. Wall Street bankers call this “leverage.”
- Pay for home improvements.
Negative reasons for a mortgage cash-out refinance abound, including:
- Buying a luxury item, such as a boat, motorcycle, or RV.
- Using the cash to invest in the stock market.
- Taking a vacation.
- Buying household items that do not improve the resale value of the property.
Pitfalls of Cash-Out Refinancing
A cash-out refinance increases the debt load on a property. Used repeatedly, cash-out-refinances can cause a homeowner to fall into foreclosure if the homeowner ever loses their income. This can best be illustrated with an anecdote shared by a Bills.com reader.
“I bought my home almost 30 years ago for $77,000. Since then, the property values in my neighborhood shot through the roof, so to speak. I refinanced every 5 years or so, and the last time I refinanced the property was appraised at $790,000. I just lost my job, and cannot afford my mortgage payment. To top it off, the balance of my latest refinance is almost $100,000 more than today's market value of my house. I'm upside down...”
The lesson in this reader’s message is clear: Had the reader not ridden the wave as his house value rose, he would:
- Be near the end of the term for his original mortgage
- Have a much smaller monthly payment
- Not be underwater.
Had the reader never refinanced, or stopped cash-out refinancing 10 or more years ago, he would be in a position to sell the property at market prices, if necessary, and not be concerned about a short sale or deed in lieu of foreclosure.
The lesson in this cautionary tale is clear: The reader used his home equity as a piggy bank, which was not a problem until the economy slowed and the reader lost his job. Think of cash-out refinancing as a strategic action, and not as a tactical or casual transaction.
Refinance With Cash-Out, Taxes & Other Consequences
Some Bills.com readers have asked how to report the “income” from their mortgage refinance. A mortgage refinance with cash-out is cash-flow, but it is not income. Because it is not income, it is not taxable, nor must it be reported on your income tax return.
Refinance with cash-out also has no bearing or consequence on a person's Social Security retirement benefits or Medicare eligibility. If you currently receive Medicaid, consult with a Medicaid counselor to learn if and how the cash from refinance with a cash-out impacts your Medicaid eligibility.
Bills.com offers two resources to help you estimate the cost of a cash-out refinance.
First, go to the Bills.com mortgage refinance calculator to learn more about your refinance options, including the costs of a cash-out refinance.
Second, see When does it make sense to refinance a mortgage loan? to see the math you need to make a go/no-go decision on a mortgage refinance.
Regarding timing, as these words are written in the third quarter of 2011, rates are at near historic lows. Rates will probably not stay low forever, which makes now a good time to apply for a mortgage refinance.