4 alternatives to a cash-out refinance

Dahna Chandler
The Mortgage Reports contributor

Cash-out refinance not always the cheapest money source

If you need money for things like home improvements, debt consolidation, or investments, you may be tempted by a cash-out refinance.

That means you refinance with a larger loan than you need to pay off your old mortgage, and take the difference in cash at the closing.

This refinance might be the best and cheapest source of funds, but it could also be an expensive mistake.

Here’s what you need to know before you apply.

Check your best options to tap into home equity. (Dec 4th, 2021)

The added cost of cash-out refinancing

The biggest drawback of most cash-out refinancing is the added fee, and the way lenders calculate it. Fannie Mae, for instance, charges .375 percent to 3.125 percent of the entire loan amount in risk-based surcharges for a cash-out refinance.

That’s right — you calculate the fee based on the entire loan amount, not just the cash-out portion.

If you want a relatively large amount of cash, the deal may make sense, because mortgage rates are usually much lower than other types of borrowing.

However, if your loan amount is large, and the amount of cash is not, it could be an expensive way to borrow.

Suppose you refinance a $400,000 mortgage, with an additional $20,000 in cash out. If your surcharge is 1.875 percent, that’s a cost of $7,875, which is almost 40 percent of the cash you want.

You’d be better off using a credit card or hitting up your local loan shark.

Cash-out refinancing = More hoops

A cash-out refinance is not quick cash you’ll repay fast. Underwriting and eligibility guidelines are stricter for these loans and they can take longer to close than shorter term financing.

For instance, Fannie Mae allows you to purchase or refinance primary homes with 97 percent loans, as long as you don’t take cash out. But you can only go to 80 percent if you want cash out.

Loans that require minimum FICO scores of 660 for cash-out only mandate 620 scores for purchases.

It is worth noting that you can avoid the surcharges and stricter underwriting by choosing government-backed refinances like FHA and VA. Those programs have their own sets of upfront fees, though, and they may not make sense if you have significant home equity.

Stretching out repayment, sucking up home equity

Cash-out refinancing means you’ll have a bigger mortgage and probably a higher payment. You’ll also burn up some home equity, an asset just like your 401(k) or bank balance.

This is not something to do lightly.

Refinance Your Loan To Current Mortgage Rates Without “Starting Over” At 30 Years

In addition, taking a cash-out refinance means resetting the clock on your home loan. You pay more over time by adding those extra years and interest to a new mortgage.

Fortunately, there are alternatives that can be cheaper and safer.

Reinforcing bad spending habits

If the reason for your cash-out refinance is consolidation of consumer debt, consider other options before you take out this loan. Depleting home equity to pay off debt accrued buying things that don’t outlast the debt is poor money management.

This method of paying those debts frees up your credit for you to spend yourself into financial trouble again. Then you might be tempted to do another cash-out refi to pay this new debt, making this a vicious circle.

Foreclosure risks are real

Several Federal Reserve studies found defaults on cash-out refinances are higher than for regular refinancing. When home values fell a few years ago, homeowners who had tapped their equity often found themselves owing more than their property was worth.

Boomerang Buyers Can Get A Mortgage After Deed In Lieu Of Foreclosure

If either home values or your income drop substantially anytime during the loan term, you could face loss of your home. Without equity, it’s very hard to sell if you need to move or if your payments become unaffordable.

When is a cash-out refinance the best option?

The cash-out refinance can be your best choice in these cases:

  • The amount of cash you want is high relative to the balance of the loan you’re replacing, and the terms of the new loan are better than those of your current loan.
  • You need a large sum and want a government-backed loan and will finance more than 80 percent of your home value. Government loans like FHA and VA let you take more cash and don’t have risk-based surcharges.

Ask lenders to show you other options and help you compare costs when you’re considering cash-out refinancing.

Alternative #1: Personal loan

Personal loans are faster to process and much easier to get than mortgages. You can use a personal loan for home improvements, debt consolidation, major purchases or other expenses.

Instead of repaying the loan for 15-30 years, you’ll pay this debt off in about five years. The interest rate depends on your credit rating, and will probably be higher than that of a mortgage.

However, the costs are low, and with a shorter term, you’ll still pay less over its life than with a cash-out refinance. Plus, sometimes you can receive funds in as little as 24 hours.

It might also improve your credit by adding another line of credit to your credit history. This could be valuable if you’ve had recent financial challenges that damaged your credit.

Alternative #2: Home equity line of credit (HELOC)

This is often a better financing strategy if you don’t need a large lump sum for a big purchase or project. A HELOC also makes good sense if you already have ideal loan terms.

HELOC Or Home Equity Loan? What’s Best For You?

With its lower closing costs and added flexibility, a HELOC is usually less costly than a cash-out refinance, and it takes less time to close. There aren’t limitations on its use, and you only pay interest on the amount of credit used.

You can use the funds for any purpose, including home improvement projects, annual costs like college tuition, or financing a gap in business revenue.

Alternative 3: Refinance your first mortgage, add a second mortgage

If you can improve on the terms of your first mortgage, that doesn’t mean a cash-out refinance is automatically your best deal.

Depending on the amount of cash you want, it might be less expensive to refinance your first mortgage with a cheaper rate-and-term loan and then add a second mortgage.

This can be a fixed home equity loan (best when you need a lump sum) or a HELOC (best for ongoing needs over time).

Alternative 4: Find other sources of cash

If you have vehicle loans at high interest rates, see if you can refinance them. That will give you lower payments and you can use the savings to pay other debt.

Look at selling valuable collections,  luxury items or things you’re not using. If there’s still debt left after your selling spree, see a credit counselor about restructuring that to pay it off. They also can help you develop better spending habits.

Consider starting a side hustle using high-demand skills you already have. Look for ways to generate income in the gig economy but carefully research their costs and legal requirements.

Borrow from family, applying for zero-interest balance transfer credit cards, or borrow against your 401(k) and deduct payments from your paycheck.

These options reduce your debt load or give you better terms than a cash-out refi or even other credit.

What are today’s mortgage rates?

Current mortgage rates for rate-and-term refinances and cash-out refinancing are affordably low. However, you still need to compare options and shop among competing mortgage lenders to pay as little as possible for your next loan.

Verify your new rate (Dec 4th, 2021)