By Eric Tyson, Robert S. Griswold

A cash-out refinance differs from the cost-cutting and the restructuring refinances in one important aspect — instead of replacing your current loan with another one for the same amount of money, you pull extra cash out of the property when you refinance it. You can do a cash-out refinance in two ways:

  • Get a new first mortgage. If you’re going to refinance your existing mortgage (because you want to cut costs or must restructure your financing), this situation could be an ideal opportunity to free up some of that equity you’ve accumulated. As long as getting extra cash won’t jack up your new mortgage’s interest rate and you have a good use for the money (such as investing in a profitable business or paying off a pile of high-interest-rate consumer debts), go for it. However, be sure you can afford to borrow all this extra money.
  • Get a home equity loan. Don’t disturb your existing loan if you’re happy with your present first mortgage, if you want to tap only a small amount of your equity, if you won’t need all the cash at once, or if you don’t need the money for very long.

Pulling cash out of your property may jack up your refi mortgage’s interest rate. Why? Lenders have gathered statistical proof over the years that taking cash out of property for nonmortgage purposes (versus pouring the money right back into the home by adding a bathroom or modernizing the kitchen, for instance) increases the probability of a future loan default.

Due to a huge increase in foreclosures between 2007 and 2012, lenders started putting cash-out refinances under a microscope. Lenders now impose extremely stringent loan restrictions on any market they consider risky because home prices in the area are declining. Be sure to ask your lender whether your property is located in what it considers a declining market.

Lenders believe that the lower your property’s loan-to-value (LTV) ratio, the lower the odds that you’ll eventually default on your loan — and vice versa. Lenders generally charge higher interest rates and loan fees or make you pay mortgage insurance for purchase loans if the LTV ratio exceeds 80 percent. For cash-out refinances, on the other hand, many lenders jack up rates and fees when the LTV ratio exceeds 75 percent of appraised value.

To see the difference this policy makes: Suppose you put $30,000 cash down and got a $120,000 first mortgage with an 8 percent interest rate ten years ago when you bought your dream home for $150,000. The LTV ratio then was a nice, safe 80 percent (your $120,000 loan divided by the $150,000 appraised value).

Fast forward to today. You’re ecstatic. Your home just appraised for $225,000. You intend to replace the faithful old loan you’ve had all these years with a new $180,000 first mortgage, which is 80 percent of the current appraised value . After paying off the $105,000 remaining principal balance of your old loan and $5,000 of refi expenses, you believe you’ll get a check for $70,000 ( cash out of the refi).

“Wow!” you think to yourself. “I’ll have my $30,000 out of the house and another $40,000 to boot. And I’ll still have $45,000 equity left in the property . I can buy that red convertible I’ve been dreaming about, take a first-class cruise around the world, and still have cash in the bank when I get home. Life is good — and so is home ownership.”

Not so fast, dear reader. Before you mentally spend all that cash, see whether your lender is one of those that increases interest rates 0.25 to 0.5 percent on 80 percent LTV cash-out refinances. If so, either reduce your refinance’s LTV ratio to 75 percent or shop around to see whether you can find a lender with equally competitive rates on 80 percent LTV cash-out refinances. Some lenders won’t even offer cash-out refinancing.

The cash-out refinance may seem like found money. It isn’t. You probably worked pretty darn hard for the cash you used to buy your home. You’re working just as hard to pay off your loan. The equity you’re accumulating in your property can be transformed into retirement income someday or used for another worthwhile purpose unless, of course, you squander it. Never borrow money needlessly.

Your home isn’t a piggy bank and if you’re a “serial refinancer” always seeking to have the latest depreciable technology or consumer item, then you’re asking for trouble and will miss out on one of your best sources of retirement funds — a home that you own “free and clear.”