When you accumulate equity in your home, you have the option to take cash out of your home. This refinance is called a cash-out refinance. When you exercise this right, you take cash above and beyond the outstanding principal balance on your current loan. This is usually an option for homeowners who have a minimum of 20% equity in their home. Just because the cash is there, though, does not mean you should touch it. Let’s explore when a cash-out refinance makes sense in terms of major expenses.
Home Improvements Usually Pay Off
Home improvements are one of the best major expenses to pay for with your cash-out refinance. Of course, the best option is to pay cash, but not everyone can afford it. This is especially true when you make major renovations to your kitchen or bathroom. It is acceptable to use the equity in your home for home improvements because you will see a return on your investment. Of course, not every change you make will have an impact, but things like kitchen or bathroom remodeling definitely have an effect. Things like adding a deck or finishing the basement may or may not have a direct impact. Consult with your local appraiser to see which changes you would see the best return on before deciding how to spend your money.
Don’t Use Your Home Equity for a Vacation
If you have a dream vacation in mind, don’t use your home equity to pay for it. This might seem like a good idea since the money is just sitting there, but it gets expensive. A vacation is considered a short-term expense. It is something you could likely save for on your own. If you use the equity in your home to pay for it, you pay for the vacation for the next 20 to 30 years, depending on the loan’s term. Think of the interest expenses that add up over that time. Your dream vacation just turned into a very expensive vacation.
Pay for Tuition with Home Equity with Caution
Whether you should use your home equity to pay for college tuition depends on the circumstances. Do you currently have an interest rate in the 5% range? If so, chances are you could secure a lower interest rate even with a cash-out refinance. This allows you to gain access to the equity in your home and pay your student’s tuition or room/board without issue. You will pay interest on the full amount for the full term of the loan, but it may cost less than a student loan would cost.
However, you have to think long and hard about this decision. You put your house on the line when you take out a cash-out refinance. This means if you defaulted on the mortgage, you lose your home. Your child still gets to go to school, but you have nowhere to live. This is not to say that this will happen. However, you need to think of the long-term effects. Do you have a plan in place if you were to lose your job or fall ill? Mortgage companies don’t care what goes on in your personal life – they want their payments on time.
Consolidating Debt is Not a Major Expense
Many people think consolidating debt, such as credit cards, is a good idea with their home equity. While you can get a lower interest rate and have only one loan to pay, it is not always a good idea. Unless you are very disciplined with your finances, you could end up right back where you started. Consolidating your credit card debt means paying your cards off now. This leaves them open for future purchases. If you were to do this, you could end up charging expenses in the future – now you have double the debt. This is in addition to the fact that your mortgage payment is much higher. A cash-out refinance requires you to pay the full principal and interest each month, which will be much higher than the minimum credit card payment credit card companies require you to pay.
The bottom line is that you need to figure out how your major expenses will affect you in the end. Will you see a return on your investment? Home improvements are an obvious choice. Other things, like adding appliances or purchasing furniture may or may not add to the value of your home. Expenses, which have a short-term return, such as tuition, vacations, or other large purchases, should not be considered a major expense worthy of a cash-out refinance.
The best way to think about whether or not you should pay for a major expense with the equity in your home is to consider the long-term effects. Is it an absolutely necessary expense? Is it worth putting your house on the line for it? Lastly, do you have a plan to pay for the mortgage if something were to go wrong? The equity in your home is a serious investment that requires careful planning so that you do not throw it all away. Keep in mind that you have to make full payments on this mortgage for the full term, which could be up to 30 years.
If you decide the cash-out refinance is the way to go, shop around with different lenders. Find the one who offers you the best rate and the lowest closing costs to make the most of your investment.
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