eli5: What is cash-out refinancing and why did so many homeowners choose to do this during 2020-2021? Also, are there any hidden dangers in this type of refi that are less talked about?
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According to Google, it’s when you take out a New mortgage for more than you owe on your current mortgage, but less than your homes current value. You get the difference between New loan amount and the loan balance at closing…
The hidden danger I’d say would be that it’s not really free money… you’re still taking out a bigger loan you still have to pay back, it could just give you some cash on hand, and hopefully the refinance would be getting you a lower interest rate (which means the now bigger loan will take even longer to pay off)
All my 2 cents, I’m no expert
I don’t know if I’d call it a danger, but the downside is that you’re starting over on your mortgage. You’re taking the equity out that you’ve put in over the years, which is something you might really need later on in life. You’re cashing in now and hoping it won’t be a bad decision in the future.
It was a way to get a lower interest rate on their mortgage AND pull out some equity to remodel, add a deck, install a pool. Say they have a mortgage at 4.5% and owe $200k on a home bought for $400k. They take out a new mortgage at 3% for $250k, meaning they now have $50k to spend on a new kitchen. It drops their equity from 50% to 38%, but new kitchen will also boost home value, their monthly mortgage payment goes up only a little because of the lower rate.
Let me use a hypothetical example. I’m going to presume this person has been just fine through the last two economic crises.
In 2012, you buy a home for $170,000 (US median price) using an FHA %3.5 down payment loan. You pay about $920 per month plus taxes and insurance. In 2021, you’ve paid down your loan to about $135,000, but your property value has increased to $350,000.
A bank is more than happy to loan you $280,000 at a great rate – you need somewhere to live and you have a lot to lose ($70,000 in equity) if you default. So you pay off the old loan and keep $145,000 for yourself. Because of the low interest rates, your new monthly payment only increases to about $1260.
There are three drawbacks that I see:
1. You have a higher payment
2. Your new loan ends in 2052, ten years later than your old, cheaper loan.
3. You should spend the money wisely, you’re going to pay for it for a long time. Do you have the discipline?
For some people, the drawbacks are very worth the extra cash. Install an $80,000 solar system and get rid of your electric bill. Pay off high interest credit cards or student loans. Make some repairs and upgrades on your home.
Other people squander the money.
Still others choose not do it at all.
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