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This article first appeared on the Credible blog.
As a homeowner in a market where mortgage rates are low and home values are high, you might be tempted to cash out your home equity to use as investment capital. You could use the money to invest in stocks, real estate, or another investment, and hope to earn a higher rate of return than the interest rate on your new mortgage.
The potential benefit is clear: more money. But this strategy also has serious risks, not the least of which is the possibility of losing your highly leveraged home to foreclosure should misfortune knock on your door.
How to use a cash-out refinance to invest
A cash-out refinance replaces your current mortgage with a larger mortgage and gives you the difference to use however you want. It’s different from a rate-and-term refinance, which replaces your current mortgage with a mortgage that’s the same size.
Guidelines vary somewhat by lender, but you’ll typically need to meet these requirements to do a cash-out refinance:
Credit score of at least 620
Debt-to-income ratio (DTI) no higher than 50%
Enough home equity to still have 20% after cashing out
You can use the cash you take out of your home for any purpose, including funding an investment.
Investing in the stock market with a cash-out refinance
At a glance: You can potentially earn income when stocks pay dividends and gain capital when stocks increase in value — but there’s always the possibility your investments might lose value.
People invest in stocks for the opportunity to earn a high rate of return and to avoid the potential headaches of investing in real estate.
Because stocks can be volatile — their value can change significantly and frequently — they’re best suited for long-term investors. If you’re comfortable buying and holding, you may ultimately sell at a considerable profit.
Of course, there’s no guarantee any stock will go up in the short run or long run.
Buying and selling stocks is free in some cases; other times, you may pay a small transaction fee called a commission. There are no ongoing costs associated with holding individual stocks.
Might gain value: When a stock’s price goes up, it’s called capital appreciation. Historically, the stocks in the S&P 500 have appreciated a lot, offering significant gains to buy-and-hold investors. The annualized return of this stock index is 9.25% (before inflation) from 1871 to 2020.
May pay dividends: Some stocks pay investors small amounts of income, called dividends, each quarter. These stocks are usually associated with well-established companies that have decided to return a portion of their profits to their shareholders.
Can offer diversification: Buying a single stock is considered fairly risky because if that stock performs poorly, you could lose all your money. The more stocks you buy in various sectors, the more you limit your exposure to major losses. Diversification also helps with volatility: While the individual stocks in your portfolio may go up and down in price, holding many stocks can help your overall portfolio maintain a steadier value.
Shareholders get voting rights: Shareholders who purchase individual stocks can vote on corporate actions and potentially influence corporate policies. The vote of one individual owning a small number of shares will not change anything, but many investors with a common goal who vote the same way can effect change.
Might lose value: Stock prices do not always go up. A stock can become completely worthless overnight, meaning you’ll lose all the money you paid for it. Permanent declines in value can happen even with companies that have a long track record of success: Sears is a good example. The only benefit of losing money on a stock is that you can claim a tax deduction on the loss after you sell.
Dividends aren’t guaranteed: Once a company starts paying dividends, it usually tries to keep paying dividends. It also tries to keep paying the same or higher dividends. It’s a badge of honor for a company to have a long history of stable or increasing payments to shareholders. But just as capital appreciation is not guaranteed, neither are dividends.
Value can be volatile: In addition to losing value, stock prices can be volatile. That up-and-down ride can be too much for some investors, even though the gains and losses are only hypothetical until you actually sell and lock in a profit or loss.
Not a good short-term strategy: While there are various short-term strategies for trading stocks, those strategies have a lot in common with gambling. Experts generally recommend only putting money in stocks as a long-term strategy, meaning you won’t need to pull the money out for many years and you’ll have the flexibility to sell when the timing is ideal.
Credible can help you get started with your cash-out refinance. You can compare partner lenders and see prequalified refinance rates in just a few minutes.
Investing in real estate with a cash-out refinance
At a glance: Tenants can help pay your mortgage (plus you can enjoy certain tax benefits) but finding a good tenant isn’t always easy and selling the home could prove difficult if the market isn’t in good shape.
A cash-out refinance on your home can be used to cover the down payment and closing costs on a second home or investment property, or even to pay for it outright. The proceeds from a cash-out refinance are not taxable.
People invest in real estate for the opportunity to earn income from tenants and one day sell the property for more than they paid for it. Federal tax law also offers ongoing benefits for owning and operating an investment property as well as for selling it.
Real estate is also a less volatile asset class than stocks.
Tenants (or vacation renters) are not always easy to find, however, and some may avoid paying you or may damage your property. Further, there is no guarantee your property will gain value, and the transaction costs associated with buying and selling can be high, especially if you’re financing the property.
Might gain value: In some locations, real estate can provide incredible returns through a combination of skill and luck. The skill part involves buying in an area that seems like it will become more desirable over time. The luck part involves that prediction playing out.
May provide rental income: Buying a rental property and leasing it out to tenants can provide steady income and help build equity. Rent tends to increase over time, giving you a form of income that keeps pace with or even exceeds inflation.
Fixer-uppers can offer high ROI: Purchasing a poorly maintained or outdated property and fixing it up can be a way to quickly build equity in real estate. However, repairs and upgrades sometimes prove more costly than expected. The market might also decline and your property value may not increase as much as you planned on.
Tangible: There’s something to be said for owning an investment you can see, touch, and live in. Real estate has obvious utility, especially if you’re buying a second home or vacation home rather than an income property.
Considerable tax benefits: Rental property tax deductions help offset income your property generates, and you can enjoy these savings even if you claim the standard deduction on your personal tax return.
Might lose value: There’s no guarantee the property you buy will gain value. A location can become less attractive or less valuable for many reasons: employers leaving town, excessive taxes and regulations, natural disasters, upticks in crime, or competition from newer properties.
High transaction costs: Purchasing an investment property with financing means paying closing costs that typically amount to 2% to 5% of the amount borrowed. Selling a property means paying a real estate agent’s commission: the traditional industry standard is 6%, though increased competition means you can often find a better deal.
Slow appreciation: For the United States as a whole, home values have generally increased slowly and steadily over the last several decades. Of course, we’ve seen exceptions twice in the last 20 years — during the 2008 housing crisis, and more recently during the pandemic housing boom.
Illiquid: If you want to sell your property quickly for cash, you may have to accept a fire-sale price. Otherwise, you could be waiting months or even years to find a buyer at the price you want.
Ongoing maintenance fees: Buildings don’t take care of themselves. Natural elements and human inhabitants will gradually — and sometimes suddenly — wear them down. You’ll have to spend money to maintain your real estate investment and keep your tenants comfortable and safe.
Should you get a cash-out refinance to invest?
Leveraging your home to make a higher-risk investment isn’t a good idea for most people. In other words, doing a cash-out refinance — which involves reducing your home equity — and using the money to buy stocks or real estate is a strategy best reserved for a knowledgeable investor with an above-average risk tolerance.
It might make sense to do a cash-out refinance to invest under one or more of these circumstances:
Refinance rates are low
You’ll get a better rate on your home mortgage when you refinance
You have excellent credit
Your emergency fund can cover at least six months of essential living expenses (including expenses for your new real estate investment, if that’s what you’re doing with the money)
You expect to earn a higher return on your investment, after inflation and taxes, than you’ll pay to close on and carry your new mortgage
You can cash out a large enough chunk of equity and/or lower your rate enough that the closing costs are worth paying
Closing costs are minimal and the lender isn’t charging a higher interest rate to compensate
When investing with a cash-out refinance makes sense
Raquelle is 45 and has a credit score of 825. She has a 30-year mortgage with a $100,000 balance. She paid $200,00 for her home that’s now worth $400,000. Her interest rate is 4.5%. She also has a large emergency fund.
Raquelle finds a lender who will let her do a cash-out refinance for 90% of the home’s value at an interest rate of 3.5% for 15 years. That means she can borrow $360,000. After paying off her $100,000 mortgage, she has $260,000 to invest.
After boosting her emergency fund and retirement savings, she uses $180,000 to pay cash for a condo in a safe, desirable area that offers many possibilities: short-term vacation rental, long-term home rental, or future retirement abode if she one day decides to downsize.
Is it a good idea? Yes. Raquelle’s house will be paid off by the time she’s 60, and she’ll fully own two properties that she can live in, rent out, or sell to help fund her retirement along with her 401(k), IRA, and cash savings. In Raquelle’s case, cash-out refinancing is a savvy financial move.
When investing with a cash-out refinance doesn’t make sense
Raquelle’s cousin William wants to emulate her success, but after they talk, William realizes cashing out his equity to invest isn’t prudent. He’s only a few years into his 30-year home loan and doesn’t have much equity.
William already has a good interest rate too. At 3%, it’s not much higher than the best available rates in the current lending market. In addition, William’s credit score is not high enough to get him a better rate.
Is it a good idea? No. William isn’t in a good position to do a cash-out refinance — let alone use his equity for an investment. But he still owns his home and can always use his leftover monthly income to invest extra in stocks or save up for a future investment property.
Find out if cash-out refinancing is right for you. Credible makes it easy to get actual prequalified rates without impacting your credit score.
About the author: Amy Fontinelle is a mortgage and credit card authority and a contributor to Credible. Her work has appeared in Forbes Advisor, The Motley Fool, Investopedia, International Business Times, MassMutual, and more.