Owning a home can be a great investment. If you’re also trying to eliminate debts, finance a home renovation, pay for college, or increase your retirement contributions, you might want to consider tapping into your equity with a cash-out refinance.
Doing so allows you to borrow your equity as cash, which you repay over time as part of your mortgage at what is typically a lower interest rate than other types of credit.
At the same time, it’s also a decision that should be taken seriously. Treating your home like a bank by withdrawing money from it could be a slippery slope. And just like with any major financial move, there are tax implications to consider.
Here’s a guide to the benefits and tax implications of cash-out refinancing:
- What Is Cash-Out Refinancing?
- 4 Benefits of Cash-Out Refinancing
- Cash-Out Refinancing Tax Implications
- Cash-Out Refinancing Alternatives
- The Bottom Line on Cash-Out Refinancing Benefits and Tax Implications
What Is Cash-Out Refinancing?
Cash-out refinancing involves taking out a new mortgage based on the current value of your home. The new loan is used to pay off the balance on your old mortgage — and any money left over is yours to do with as you please, says Josh Westreich, branch manager at U.S. Mortgage of New Jersey in Hackensack, New Jersey.
If you have significant equity in your home from paying down the principal on your mortgage or from your property increasing in value, that means you could borrow a large sum cheaply — if qualified — and repay it as part of your new mortgage.
Other cash-out refinancing benefits for qualified homeowners include the ability to get a lower interest rate and monthly payment, switch to a fixed-rate mortgage from an adjustable-rate mortgage, or change to a 15-year mortgage from a 30-year term.
For example, say you want to remodel your home. You bought it with a 30-year, fixed-rate mortgage for $350,000 at a 4% interest rate. Since then, you’ve paid down your principal to $250,000. If your home’s value has remained steady, you could refinance to a new loan for $350,000, pay off the original mortgage, and have $100,000 to put toward the remodel.
Just remember, you’ll pay closing costs on your new loan, and your monthly payment can change based on how much you borrow, the interest rate, and the new loan term.
4 Benefits of a Cash-Out Refinance
There are some clear benefits to cash-out refinancing, especially if you use the money for expenses that add long-term value.
Acceptable reasons for a cash-out refinance include consolidating debt and lowering your monthly expenses, Westreich says.
“After that, estate (and) life planning, or home improvement would be valid,” he says.
Here are four benefits of cash-out refinancing.
1. Increase your home’s value with a renovation
Home prices have risen steadily since the beginning of the pandemic. According to the Federal Reserve Bank of St. Louis, the median home sales price has increased 24% from the start of 2020 through the end of 2021.
Borrowing that appreciated equity and putting it into something like an updated bathroom or kitchen likely would raise your home’s value even further, and yield a better return whenever you’re ready to sell.
2. Consolidate and pay off your debts
If you have credit cards, car loans, or student loans, consolidating your debts with a cash-out refinance could help you save money on interest and make them easier to pay off. A cash-out refinance lets you repay those high-interest debts as part of your mortgage at a lower interest rate and over a longer period. The difference in your mortgage payment likely would be small compared to what you were paying monthly for those other debts, and paying off your mortgage would retire them completely.
The advantages of consolidating debt with a cash-out refinance depend in part on your ability to avoid accumulating new debt. Continuing to rack up credit card charges will land you back in the same place, so be sure to avoid repeating any financial mistakes.
3. Fund new ventures
Maybe you want to start your own business, purchase a second home, or invest. You need funding to do so, and cash-out refinancing is one way qualified homeowners could borrow a lump sum cheaply.
If you can find investments or buy properties that provide a return higher than the interest rate you would pay on a cash-out refinance, it may be a good move. Just remember that investing always carries risk, and it’s always best to consult with a qualified financial planner before making any major investments.
4. Save money with a lower interest rate
Refinancing to lower your interest rate could be quite lucrative.
If we use the same example from earlier, a $350,000 mortgage with a 20% down payment and 4% interest rate will cost $201,235 in interest payments over the 30-year loan term. The same loan at a 3% interest rate would cost $144,977 in interest — a savings of $56,258.
When refinancing, much depends on how far along you are in repaying the principal. Early on, you pay more interest, and refinancing to a lower rate could save you more money. But the longer you have your loan, and the more you’ve paid down the principal, the less you would save with a lower interest rate.
Cash-Out Refinancing Tax Implications
Receiving a lump sum of cash in your bank account feels great, but do you have to pay taxes on that sum?
The answer is no. The IRS doesn’t consider the funds from a cash-out refinance as taxable income since it’s money you’re borrowing from the value of your home.
Where things get tricky is when and how much interest you can deduct. The interest on your original loan balance remains deductible. If you borrow more than that amount with a cash-out refinance, you can only deduct the interest paid on the difference if that money is used to make what’s called a capital improvement.
A capital improvement is a permanent addition to your home that increases its value. Examples include replacing the roof, adding a bedroom, or installing a central heating and cooling unit.
It’s always a good idea to consult with a qualified expert to determine what tax deductions you can get.
What renovations count as tax deductible?
When it comes to renovations that are tax deductible with the money from a cash-out refinance, they don’t need to be expensive or elaborate. The renovations can range from something as simple as installing a security system to as expensive as building a pool.
Here are some examples of tax-deductible home improvements:
- Adding a bedroom or bathroom.
- Building a fence.
- Updating your roof.
- Adding solar panels.
- Updating your heating and cooling systems.
- Upgrading windows.
Examples of nondeductible home improvements are:
- Fixing a cracked window.
- Power washing.
- Cleaning rain gutters.
Again, consult with a qualified expert to determine what tax deductions you can get.
Cash-Out Refinancing Alternatives
A cash-out refinance isn’t the only way qualified homeowners can borrow against their equity. Here are some other options:
- Home equity line of credit. This works like a credit card, with the amount you borrow secured by your equity. HELOCs typically have a limit on both how long and how much you may borrow, and the interest rates are usually variable.
- Home equity loan. This is a more conventional loan, taken out for a lump sum secured by equity and repaid with its own interest rate and loan term separate from the main mortgage. It’s also known as a second mortgage.
The Bottom Line on Cash-Out Refinancing Benefits and Tax Implications
In times of high inflation, having a large sum of cash in your pocket isn’t the best solution. However, if you’re a qualified homeowner with a plan, cash-out refinancing could be a smart decision to consolidate debts, invest in another property, or increase the value of your current home.
