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'You're almost using someone else's money for free': How refinancing your mortgage can help build wealth

A cash-out refinance lets you extract home equity that you can then invest at a higher rate of return.

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Jillian Johnsrud and her husband bought their first home together eight years ago, paying in cash with a decade's worth of savings. In the intervening years, Johnsrud, a life coach who achieved financial independence at age 32, has leveraged the equity to buy new investment properties. And recently, the couple pulled $250,000 out of their current home — to invest in the market.

To access the money, the Johnsruds made a move called a cash-out refinance. These loans let homeowners sign a new mortgage and withdraw some of their equity in cash.

The current market offers a unique opportunity for this move. Home values have jumped 15% over the past year, according to Zillow, leaving homeowners with record-high equity to tap. Mortgage rates, meanwhile, have hovered near record lows, making it less expensive to borrow.

That combo means that a cash-out refi can be a smart financial move, says Greg McBride, chief financial analyst at Bankrate. "With rates as low as they are today, on an after-inflation basis, you're almost using someone else's money for free, if you're disciplined about how you employ it," he says. 

Plenty of homeowners are seeing the potential. Amid a frenzy of home refinancing, cash-out loans recently made up 42% of all U.S. refinance loans — the highest share in more than two years, according to data from mortgage analytics firm Black Knight.

But a cash-out refi isn't without risks. Read on to find out what all the fuss is about, and how to decide if tapping your home equity is worth it. 

How leveraging a cash-out refi could improve your finances

By signing a new mortgage and taking the cash sum, McBride says, "it allows the homeowner to access that equity at a very low fixed interest rate." And because that cash is locked in at a low interest rate, homeowners can more easily use it in ways that generate a higher return, such as paying down high interest rate debt, or investing it — either in more real estate or in the market.  

Johnsrud says she plans to invest her quarter million in a target-date mutual fund — a low-cost investment vehicle that holds a mix of stocks and bonds that grows more conservative as the holder reaches retirement age. 

"For a lot of people it feels risky … the idea that you're risking something you need to have security in for long-term growth potential," she says. "But throughout our financial journey we've taken very calculated risks."

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It doesn't take a great mathematician to see how the Johnsruds' investment could prove lucrative over the long term. Their new mortgage rate is 3.25%, about 0.1 percentage point above the national average rate on a 30-year fixed refinance, according to Bankrate

The portfolio they're planning to invest in will tilt heavily toward stocks early on, and will shift more of its assets toward bonds over time. But even if they picked a more conservative investment than that, the rate of return they could expect to earn on their investments would comfortably exceed the interest rate they're paying on their new mortgage over the life of the loan. From 1926 through 2020, a portfolio of just 40% stocks and 60% bonds posted an average annual return of 8.2%, according to Vanguard

The same dynamic applies when it comes to paying down high-interest-rate debt. If you take out a loan at 3.5% and pay off your credit card debt, which carries an interest rate of, say, 15%, you're going to cut your interest costs and get out of debt faster, says Danielle Hale, chief economist at Realtor.com. "It can be a smart financial move, but you need to make sure you're addressing the decisions and lifestyle that got you into debt in the first place," she says.

3 questions to ask yourself before taking a cash-out refi

Before you sprint to your nearest mortgage banker's office, take a step back and assess your finances. A cash-out refi is "not to be used lightly," cautions McBride. If you haven't met certain financial prerequisites, investing your home equity in the market can be a risky move. 

Ask yourself the following three questions: 

1. Can I afford to pay closing costs?

Before you can even start thinking about future dollar signs, you're going to have to deal with closing costs up front, says AnnaMarie Mock, a certified financial planner and wealth advisor at Highland Financial Advisors in Wayne, New Jersey. "There can be substantial costs associated with a refinance," she says. "On average, we're talking 3% to 5% of the home's value that you'll either pay out of pocket or wrapped up in the loan itself."

Figure out how long it will take you to earn that money back. Experts say that ideally, you could do so in five years or less.

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2. How long do you plan to stay in your house?

"Chewing up a portion of your equity to invest elsewhere could leave you in a situation where you don't have enough equity to roll over to the next home if you want to move in the next few years," McBride points out. If you invested that money, for example, you may be forced to sell to make a down payment — a risky move given the volatile nature of the stock market. 

And if the value of your home declines after you've taken equity out of it, you could have even less money to work with. "If you're in a situation where you have to sell but the home price has fallen faster than your mortgage balance, that erodes the remaining equity stake you have. You won't have a lot left," says McBride. "If asset values are falling, there are not a whole lot of places to hide."

To get the best loan rates, most lenders require you to retain at least 20% equity after cashing out, he says. Sticking to at least 20%-25% gives you more equity to use down the line, even if home prices cool off somewhat. And remember, you'll be building equity back up with each mortgage payment.

3. Can I afford to pay the new mortgage?

If you're taking out a new, maybe bigger loan, you have to be able to comfortably afford those payments, says McBride. Experts recommend keeping your mortgage to less than three times your annual salary, and your housing costs to 25% of your income, max. That helps ensure you aren't putting your home at risk, and can use the withdrawn equity in ways that help you add to your financial security.

Johnsrud says she and her husband felt comfortable doing a cash-out refi this summer because their investment properties provide enough income to cover their new mortgage. That helps ensure they can leave their new investments in the market for the long haul, a crucial component to making the refinance pay off. "If the market crashes next week and we lose 40%, we can sit there for 10 years," she says, and ride out those short-term bumps without selling at a loss.

"We can still pay this debt, even if our primary source of income goes away," Johnsrud says. "And because we can, it really makes that risk level a lot lower for us."

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