Stuck with high-interest credit card debt that you can’t seem to pay off? Maybe you’ve thought about tapping the equity in your home to help get the credit monkey off your back.
Well, here are a few reasons why you want to think twice before doing that!
Cash-out refinances are on the rise, but look before you leap
According to the Wall Street Journal, federal mortgage clearinghouse Freddie Mac is out with new numbers that show more than eight in every 10 refinance borrowers who pulled money out of their home during the third quarter of 2018 did what’s commonly called a “cash-out refinance.”
Simply put, that means they exchanged their old mortgage for a new one with a higher principal balance — and got cash back in the process.
In just three months, people drew down the equity in their homes to the tune of $14.6 billion. As money expert Clark Howard says, “It’s like treating your home as an ATM.”
This movement was largely driven by a real estate market where values are rising faster than wage growth, which makes this an attractive pot of money to tap into in theory when financial times get tough.
Homeowners commonly use cash-out refi money to pay down other debts like credit cards. As you probably know, that plastic can carry an interest rate in the upper teens or even higher. Another common use of the funds is for home renovations.
Beware of these pitfalls when you do a cash-out refinance
While getting money of your home like an ATM may sound great in theory, there are multiple downsides to doing a cash-out refinance that you need to be aware of…
Giving up a lower mortgage interest rate
One of the downsides to doing a cash-out refinance is that if you locked in a historically low mortgage rate anytime since the Great Recession of last decade, you’re going to have to surrender it for a higher-interest mortgage rate in order to tap into your home’s equity.
For example, Freddie Mac reports a 30-year fixed-rate mortgage now comes with a rate of 4.81% (as of this writing), which is up almost an entire point from 3.99% at the end of 2017.
And rates are only poised to go higher from here for the foreseeable future.
This smells like a repeat of last decade
If you’re a watcher of economic cycles, it’s not hard to notice some distant, muted echoes of the pre-recession cash-out refi craze here. Only it seems to be happening at a slower pace this time.
The Wall Street Journal notes that cash-out refinancing topped $80 billion for three straight quarters in 2006 before the housing market went sour.
Now, in all fairness, the $14 billion in cash-out refis we saw in the third quarter of 2018 is only a fifth of the $80 billion cash-out frenzy. But it still signals a note of concern.
Look at the entire picture
If you were to do a cash-out refinance, sure, you could pay off your credit card…but you may pay thousands more in the long run on your mortgage because of the higher interest rate.
Moreover, consider this: Credit card debt is unsecured. If you don’t pay your credit card bill, there’s nothing a credit card company can do to you other than ruin your credit and/or harass you endlessly to pay your bills.
But mortgage debt is secured by your home. If you fail to keep up with your monthly mortgage payments, you’ll could find yourself out on the street.
Finally, if another massive crash in housing values were to happen like it did last decade, you could wind up “upside down” in your home — where you owe more than the home is worth and can’t sell if you need to move for work or personal reasons.
Better alternatives to a cash-out refinance
So what’s the alternative to a cash-out refi? If you’re stuck with high-interest credit card debt that you can’t seem to get out from under, money expert Clark Howard suggests trying peer-to-peer lending companies.
Peer-to-peer lending is a way to cut the banks out of the personal loan equation. It lets people go online to borrow and lend money directly to each other. Prosper.com and LendingClub.com are two of the leaders in this space.
The way it generally works is you agree to a credit check and disclose your debt-to-income ratio. Based on that information, you’re assigned what amounts to a credit risk score and a letter grade (from AA to E). Then you get access to funding with an APR that reflects the credit risk you pose to the lenders who are everyday people just like you — not bankers.
Even some big finance firms are trying to reinvent themselves with a friendlier, customer-facing approach in the personal loan space. Marcus by Goldman Sachs is one of them.
Marcus offers no-fee fixed-rate personal loans from $3,500 to $40,000 with APRs starting at 6.99% on durations from 36 to 72 months.