Risks and Downsides of Cash-Out Refinances

A cash-out refinance can seem like an attractive option for homeowners looking to tap into their home equity. By refinancing your mortgage for more than you owe and pocketing the difference, you gain access to cash for major expenses, such as home renovations, debt consolidation, or other financial goals. However, while cash-out refinances can provide short-term financial relief, they come with significant risks and downsides that every homeowner should carefully consider before proceeding.

Tapping into home equity through a cash-out refinance can be tempting but risky.

What Is a Cash-Out Refinance?

A cash-out refinance replaces your existing mortgage with a new, larger loan. The difference between the new loan amount and the remaining balance of your original mortgage is paid to you in cash. For example, if your home is worth $400,000, you owe $200,000 on your mortgage, and you refinance for $300,000, you’d receive $100,000 in cash (minus closing costs and fees). To understand the maximum amount you can borrow, check out our guide on maximum cash-out refinance amounts.

While this can provide immediate liquidity, the trade-off is a larger loan balance, potentially higher monthly payments, and increased financial risk. Below, we explore the key risks and downsides of cash-out refinances to help you make an informed decision.

1. Increased Debt Load

One of the most significant risks of a cash-out refinance is that it increases your overall debt. By borrowing against your home equity, you’re ????? taking on a larger mortgage, which could strain your finances in the long term. Unlike other forms of debt, such as credit card balances or personal loans, a mortgage is secured by your home. If you’re unable to make payments, you risk foreclosure.

For example, if you use the cash to pay off high-interest credit card debt, you may temporarily reduce your monthly expenses. A CFPB report suggests that some borrowers improve their credit scores after consolidating debt this way. However, you’re converting unsecured debt into secured debt, which puts your home at risk if your financial situation worsens.

2. Higher Monthly Payments

Because a cash-out refinance increases your loan amount, your monthly mortgage payments are likely to rise unless you extend the loan term significantly. Higher payments can stretch your budget, especially if you’re already managing other financial obligations. If interest rates have risen since you took out your original mortgage, you could face even steeper payments. Homeowners with average credit may explore loan programs for average credit and income earners to find more affordable options.

Homeowners should carefully assess their budget to ensure they can afford the new payments. Failing to account for unexpected expenses, such as medical bills or job loss, could lead to financial hardship.

A cash-out refinance can increase your monthly payments and financial risk.

3. Reduced Home Equity

Home equity represents the portion of your home that you own outright. A cash-out refinance reduces your equity, which can limit your financial flexibility in the future. For instance, if you plan to sell your home, having less equity could result in a smaller profit after paying off the mortgage and covering closing costs. Learn more about home equity in our guide on home equity loans.

Additionally, if home values decline, you could end up owing more on your mortgage than your home is worth—a situation known as being “underwater.” This makes it harder to sell or refinance your home without bringing cash to the table.

4. Risk of Foreclosure

Since a cash-out refinance is secured by your home, defaulting on the loan puts your property at risk of foreclosure. If you use the cash for non-essential expenses, such as vacations or luxury purchases, you’re essentially gambling with your home. Even if you use the funds for necessary expenses, such as medical bills, the increased debt load could make it harder to keep up with payments, especially if your income decreases.

Foreclosure can have devastating consequences, including damage to your credit score and the loss of your home. Homeowners should weigh the potential benefits of a cash-out refinance against the risk of losing their property. For those with lower credit scores, loan programs for bad credit or low-income borrowers may offer safer alternatives.

5. Closing Costs and Fees

Like any mortgage refinance, a cash-out refinance comes with closing costs, which typically range from 2% to 6% of the loan amount. For a $300,000 loan, this could mean $6,000 to $18,000 in fees. These costs reduce the amount of cash you receive and increase the overall cost of the loan. For a detailed breakdown, see our article on cash-out refinance costs and fees.

In addition to closing costs, some lenders charge higher interest rates for cash-out refinances compared to traditional refinances, as they view them as riskier. Over the life of the loan, these costs can add up, making the refinance more expensive than anticipated. You may also explore lender credits to offset some of these costs.

Closing costs and fees can significantly reduce the cash you receive.

6. Longer Loan Term

To keep monthly payments manageable, some homeowners extend the term of their new mortgage during a cash-out refinance. While this can lower your monthly payments, it also means you’ll be paying off your mortgage for a longer period, potentially increasing the total interest paid over the life of the loan. For more insights, read our tips for refinancing with a longer term.

For example, if you’re 10 years into a 30-year mortgage and refinance into a new 30-year loan, you could end up paying interest for an additional 20 years. This can significantly increase the cost of borrowing and delay your ability to own your home outright.

7.kej Potential for Misusing Funds

One of the less-discussed risks of a cash-out refinance is the temptation to misuse the funds. Without a clear plan, homeowners may spend the cash on non-essential purchases, such as luxury goods or speculative investments, rather than using it for financially sound purposes like home improvements or debt consolidation.

Even when used for legitimate expenses, the funds may not yield the expected financial benefits. For example, home renovations don’t always increase a home’s value by as much as they cost, and investments carry their own risks.

8. Impact on Credit Score

Applying for a cash-out refinance requires a hard credit inquiry, which can temporarily lower your credit score. Additionally, if you use the cash to pay off credit card debt, you may be tempted to run up new balances, which could harm your credit utilization ratio and further damage your score. To improve your chances of approval, learn how to get approved for a mortgage.

If the increased mortgage payments strain your budget, you may also struggle to pay other bills on time, leading to late payments and additional credit score damage.

Alternatives to Cash-Out Refinances

Before committing to a cash-out refinance, consider alternative ways to access funds or achieve your financial goals. Some options include:

• Home Equity Line of Credit (HELOC): A HELOC allows you to borrow against your home equity as needed, often at a lower cost than a cash-out refinance. Learn more in our cash-out refinance vs. home equity loan comparison.
• Personal Loan: For smaller expenses, a personal loan may be a better option, as it doesn’t put your home at risk.
• Budgeting and Saving: Creating a budget and saving for major expenses can help you avoid taking on additional debt.

Conclusion

A cash-out refinance can provide quick access to cash, but it’s not without significant risks. From increased debt and higher monthly payments to reduced home equity and the potential for foreclosure, the downsides of a cash-out refinance can have long-lasting financial consequences. Homeowners should carefully evaluate their financial situation, consider alternatives like a HELOC, and consult with a financial advisor before deciding whether a cash-out refinance is the right choice.

By understanding the risks and planning strategically, you can make informed decisions that protect your financial future and preserve the value of your home. For more guidance, explore our resources on preparing for the mortgage loan application process.