At the height of the housing market boom, it seemed like every homeowner was taking out a home equity line of credit or performing cash out refinancing. Cash out refinancing isn’t quite as common these days, but it can still be a useful tool.

Before you decide whether cash out refinancing is right for you, let’s understand the difference between this term and a home equity line of credit (sometimes still referred to as a second mortgage).

Cash Out Refinance vs. a HELOC

When a homeowner conducts cash out refinancing, he or she refinances the existing mortgage on their home for more than is currently owed and then pockets the difference.

For example, assume you own a house valued at $500,000 and have an existing mortgage loan of $300,000. In this example, you have equity in the home of $200,000. In other words, the homeowner owns 40% of the current property value ($200,000 divided by $500,000). If the homeowner wishes to tap into $50,000 of that equity, they can execute a cash-out refinance.

In this case, the homeowner would take out a completely new loan (i.e., new terms, new rate, possibly a new lender) in the amount of $350,000. Essentially, the new loan will be used to pay off the old loan, and the leftover cash can be pocketed by the homeowner for whatever purpose he or she has in mind.

This type of refinance is like an original mortgage, in that you’ll need to pay for private mortgage insurance if you borrow more than 80% of your home’s value through the refinancing process. So if possible, it’s best to keep at least 20% equity in your home.

If the homeowner were to have taken out a home equity line of credit (HELOC), he or she would be taking out a second loan behind the existing mortgage. So if you had $200,000 of equity in your home, you could open a line of credit for $50,000 against that equity. This could be with your original mortgage lender or with a completely new lender.

With a HELOC, you’ll wind up with a separate payment from your mortgage, unlike with a refinance. Plus, HELOC’s – in part because they’re revolving loans like credit cards – tend to have higher interest rates. This isn’t always the case, but it’s typical. With a HELOC, though, you won’t have to pay closing costs like you will with a refinance (which is really rather like buying your home from yourself).

When is a Cash Out Refinance a Good Idea?

The next logical question is when is it advantageous to refinance your home for cash?

First, as mentioned above you have to have equity in your home. Second, often lenders will not let homeowners take cash-out on their property without 12 months seasoning, which means that you will need to own the home for at least 12 months.

As a result of falling home prices and the sub-prime mortgage crisis, lenders enacted tougher cash-out rules to deter investors from buying homes with zero money down, quickly refinancing them and taking cash out.

When determining whether a cash out refinance is for you, your need for the cash is obviously important; however, there are other factors to consider, as well.

For one, it doesn’t make much sense to refinance at a higher rate, like if your current mortgage rate is lower than the proposed rate on the new mortgage. In this case, it may be wiser to take out a home equity loan.

Yet, if your loan is close to reaching maturity (for example, you are 23 years into paying down a 30 year loan) financially it may not be wise to refinance at all, even if the new loan does have a lower rate. By taking cash out, you’re losing all the equity you’ve built, increasing debt, paying more interest, and basically resetting the clock on the loan.

A large and integral part of the decision entails running the numbers. Calculate what your monthly payments will be and for how long on the new loan vs. your debt payment currently. Is it worth it? Only you can answer that.

Additionally, consider how you will be using the cash. If you are going to start paying down a new loan, it’s best to spend the money on something that will add value. For instance, taking a vacation with your cash out is probably not a great idea, but using the money to remodel your home or expand your business may be.

Many people also refinance to pay off existing debt including credit cards. Although the rate will certainly be lower, it’s very likely that you’re prolonging the time it will take to pay off the debt. If you just discipline yourself to make larger payments on your existing debts, you’ll probably pay them off faster.

Also, remember that in this situation, you’ll essentially be using your home to secure otherwise unsecured debts. If you default on a credit card, the credit card company can’t come after your personal assets like your home. If you default on your refinanced loan, your lender will definitely come after your home.

Always remember that even if you don’t walk away with any cash in your pocket, as you have used all the cash made available from refinancing to pay down other debt, the bank or lender will still consider it cash-out, and it will be underwritten as such.

No matter what, constantly refinancing, even if the equity is there, is bound to result in paying more interest and principal for a longer period of time. As illustrated, a falling interest rate environment is certainly the primary driver in a cash out refinancing, but it should not be the only factor considered.