Need to find a big chunk of change to cover that major kitchen remodel? Need dollars to fund the addition of a master bedroom suite? The recent changes to the tax laws have made big changes in the deductions you can take for interest paid on home loans – but a cash-out refinance for home improvements might still be an option.
The changes to the tax laws at the end of 2017 eliminated the general deduction you could take for funds borrowed through a cash-out refinance. But depending on how you use the funds, you may still be able to deduct the interest that you pay when filing your income taxes.
How a cash-out refinance works
But what is a cash-out refinance? A cash-out refinance differs from a traditional refinance in one big way: With a cash-out version, you are refinancing for more than what you owe on your existing mortgage.
Say your home's current value is $200,000 and you owe $100,000 on your existing mortgage loan. Say you also want to spend $50,000 on kitchen and bathroom remodels. Instead of refinancing for just $100,000, the amount you owe on your mortgage, you'd refinance for $150,000, the amount you owe plus the money you want to use for your renovations.
Once your cash-out refinance closes, you'll pay back what you borrowed in regular monthly payments as usual. Only instead of paying back $100,000, which is the amount you'd have owed if you closed a standard refinance, you'd pay back a total of $150,000.
Interest deduction limits
When it’s time to file your taxes each year, you can deduct the interest that you pay when paying back your cash-out refinance. This makes such a loan even more attractive.
There are limits, though. Aaron Meyer, a lender with Settlers Bank in Madison, Wisconsin, said that homeowners can only deduct the interest on cash-out refinances if they are using the cash they received to cover home improvements that increase the value of your residence. If you use that money to pay down credit-card debt or to help cover the costs of a child's college tuition, it is not deductible, Meyer said.
But for funding home improvements? Cash-out refinances are strong options today, Meyer said. One benefit? The interest rates that come with cash-out refinances are fixed, meaning that if your mortgage rate is 4 percent when you take out your refinance it will remain at that number until you pay off your loan. Rates that come with HELOCs are variable and can rise during the lifetime of your line of credit, Meyer said.
"Cash-out refinances for home improvement will continue to be popular," Meyer said.
Paying off debt
Even if you can't deduct the interest, it still might make sense to turn to a cash-out refinance to handle debt.
Ralph DiBugnara, vice president of retail sales at Residential Home Funding in White Plains, New York, said that a cash-out refinance is a good way for homeowners to get rid of credit-card debt that comes with high interest rates, even if these same owners won't be able to deduct the interest they pay on their refinance because they're not using the money for home improvements.
"The biggest pro to cash-out refinances is even with rates up a little, interest rates are still very cheap," DiBugnara said. "The average credit-card interest rate in 2017 was around 15 percent. The average mortgage rate was around 4 percent. It's still much cheaper to pay off debt with a refinance than it would be on a credit card."
DiBugnara said that cash-out refinances can help, too, when you are ready to sell your home. As he says, there remains a shortage of homes on the market, with demand for buyers outpacing the supply of properties for sale. Older homes that have been renovated are, because of this, in great demand.
DiBugnara said that Millennials, the largest group of buyers in the market, like homes that are either new or recently renovated.
"New construction is becoming harder to find in this market, so older, remodeled homes are more in demand than ever," he said. "Refinancing your home to take out cash and use that cash to improve your home makes sense. It could pay off in windfalls in this seller's market."
Having equity gives homeowners options. They can, of course, take out that cash-out refinance. But this doesn't mean that a refinance is always the right choice. Remember, when you refinance, you are paying off your existing loan and taking out a new one. The goal is to lower your interest rates while doing so.
Just make sure the savings you receive each month from your drop in interest allows you to quickly pay back the cost of refinancing. Your lender will charge closing costs on a refinance, costs that could run in the thousands of dollars.
Be aware, too, that by refinancing, you might extend the number of months or years it takes you to pay off your loan. Say you were paying off a 30-year mortgage loan and you have 10 years of payments left. If you refinance to a 15-year loan, you now have five more years of payments to make, even though you'll be saving money each month
Robert Frick, corporate economist with Vienna, Virginia-based Navy Federal Credit Union, said that cash-out refinances make sense for plenty of homeowners. But owners should consider all their options, including home equity loans, Frick said.
"Many consumers don't realize that refinancing is just one way to tap equity for cash," Frick said. "And consumers might not know that cash-out refis are tougher to get now than they were before the crash. For prudent homeowners, the increase of home equity is good news. It opens up options for loans that, for many, disappeared after the housing boom combusted. But be sure to consider all your options."