A cash out refinance for your home could lead to a lower interest rate on your mortgage and allow you to take out some of your home's equity. However, a cash out refinance has several long-term implications for retirees living on a fixed income. Here's a look at the advantages and disadvantages of initiating a cash out refinance in retirement, and how it compares to other home loan options.
What Is a Cash Out Refinance?
A cash out refinance is a new loan on your home for more than you owe on your mortgage. The new loan covers what you currently owe on the home and includes a portion of the equity you have in your home. You receive the equity portion in cash.
For example, let's say your home is valued at $250,000 and your current mortgage balance is $150,000. This means you have $100,000 of equity in your home. You can refinance the $150,000 that you still owe, plus some of the additional equity. Your new loan might be for $200,000, and you'll receive $50,000 of that amount in cash.
A cash out refinance will include new terms for paying back the loan. There is usually a longer payment plan, such as 15 to 30 years. There is also a limit on the amount of equity you can take out of the home. Typically, "a cash out refinance allows borrowers to take up to 80% of their home value in cash," says Benjamin Schandelson, a loan originator and head of marketing at MJS Financial in Boca Raton, Florida.
The Benefits of a Cash Out Refinance
Perhaps the largest advantage of a cash out refinance is that it allows you to access equity in your home without having to sell it. "A cash out refinance can be an attractive option if you want to convert your home's equity into a lump sum of cash," says Casey Marx, founder and president of Crown Haven Wealth Advisors in Carmel, Indiana. There aren't restrictions on how the cash can be used. You could pay off high interest debt like credit card debt or renovate your home.
If you currently have a high interest rate on your mortgage, the new loan might have a lower interest rate. "A cash out refinance will likely lower your current mortgage interest rate," Marx says.
The Drawbacks of a Cash Out Refinance
The potentially lengthy terms of the new loan can be a significant disadvantage for retirees. For example, if you use a cash out refinance to get a 30-year loan at age 65, the loan won't be paid off until you turn 95. "The borrower begins a brand-new mortgage term, at a higher mortgage amount," Marx says.
There are also expenses involved with completing the transaction. "Paying closing costs for the new loan can be 5% to 6% of the loan amount," Schandelson says.
You may not be able to leave your home to heirs if you do a cash out refinance. A cash out refinance increases the amount of debt for the home. It could take many years to pay off the new loan, or your heirs may need to sell the home to pay off the remaining mortgage.
How a Cash Out Refinance Compares to Other Options
A cash out refinance is not the same as simply refinancing your home. When you refinance, you take out a new loan on your home, but you do not access any of the equity in cash. Say your home is valued at $200,000 and you have a mortgage of $100,000. You might refinance with a new loan for $100,000 that offers a lower interest rate.
A cash out refinance also differs from a reverse mortgage. With a reverse mortgage, "instead of paying a monthly mortgage bill, the bank will pay you for the equity in the home," Schandelson says. "After your passing, the bank gives your family the option to pay off the mortgage to keep the house or let the bank have it."
Another option to consider is a home equity line of credit. A HELOC operates in a way that is similar to a credit card. Rather than receiving a lump sum of funds, you draw funds when you need them to cover costs, and then pay off the balance.
What to Consider Before Getting a Cash Out Refinance
Think about what you would like to use the funds for and any upcoming changes to your lifestyle that you anticipate. "Retirees should start with a budget and a retirement plan for what the equity would be used for," says Chris Keller, partner at Kingman Financial Group in San Antonio, Texas. "Make sure to understand your goals, the reason for the money, the legacy you will leave and how it will affect your future."
You'll also want to sort through other options for accessing funds. You might decide to sell your current home and downsize, increase income by getting a side job or reduce current expenses to free up funds.