4 Mistakes to Avoid when Doing a Cash Out Refinance

A cash out refinance is like a second mortgage for a sum larger than you owe on your existing mortgage. The new loan has more favorable terms, one hopes, than your previous loan. Once it is used to pay down the balance of the first loan, any remaining funds can go straight to your bank account. Many people take a cash out refinance to pay for a major life expense, like college or a wedding. While this can be a helpful option, avoid making these mistakes if you opt for a cash out refinance. 

#1 Taking on Too Much Debt

You should maintain awareness of your total debt at any given time. It is advisable to budget for debt at the same as you budget for any other expense. This is a helpful rule of thumb: your total debts should be less than one half of your monthly salary. This includes all of your debt obligations, including student loans, mortgage loans, auto loans, personal debt and other fixed payments. If your debt exceeds this metric, you may find that you have limited funds available to meet living expense needs like groceries and entertainment.

#2 Compromising Too Much Equity

Whenever you cash out of a mortgage, you are transferring a portion of the equity you have in a home back into debt. Losing equity is damaging to your credit score. Further, losing too much equity can put you at risk for bankruptcy. You always want to make sure you have enough assets that you could reasonably sell them to pay your outstanding debts at any given time. If you have more debt than you do assets, you could not liquidate in order to avoid bankruptcy. Instead, a court would have to liquidate your assets, settle your debt, and protect you with bankruptcy.

#3 Opting for Extended Terms

You want to convert the debt back into equity as fast as possible when you cash out of a mortgage. This is hard to do if you are making low monthly payments on a very long loan. Instead, it is better to start paying down the principal debt early and as much as possible each month. The portion of the loan you cashed out should be repaid within 3 years, restoring your total equity to the same level in a short period of time. Longer loans that do not restore the equity for 7 to 10 years compromise your financial standing in the future. 

#4 Not Considering Other Options

A cash out mortgage loan is just one way to get cash when you need it. There are other personal loan options, including home equity loans, secured personal loans and unsecured personal loans that can help you get the funding you need. These loans still add to your total debt, but they do not compromise any of the equity you have in your home. Even a home equity, which uses the equity as collateral, does not actually reduce the equity you have. You can still count the home's value in your asset base each year and on your credit score.