Refinancing to Pull Cash Out of Your
Home Could Undermine Your Equity Position

Buying a first home is a financial stretch for most people. The first home usually costs you more than you anticipated for a home that offers you less than you'd hoped for. It's hard to imagine how you'll ever afford anything better.

But most first-time buyers do eventually trade up. Building equity and trading equity from one property to another is often the mechanism that makes such a move possible.Equity is the current value of a property less the liens (such as mortgages) that are secured against it. For example, if you pay $250,000 for a home using a $200,000 mortgage and a $50,000 down payment, you'll have $50,000 equity in the property.

There are several ways to increase your equity. One is by using an amortized mortgage. Every time you make an amortized mortgage payment, a portion of your payment goes to pay interest and a portion goes toward paying back the amount you borrowed (called the principal).

You build equity faster with a 15-year amortized mortgage than you will with a mortgage that's amortized over 30 years. Interest-only mortgages may provide a nice tax write-off, but they don't build equity.

Another way to increase your equity position is to make a large principal pay down on your mortgage, or pay the mortgage off completely. Home improvements that add value to your property can also improve your equity position. But the easiest way to grow your equity is through home price appreciation. Appreciation is the increase in value of a property over time.

Let's say that you pay $250,000 for your first home. Like most first time buyers, you have trouble accumulating cash for a down payment. So you put $25,000 down and finance the purchase with a first mortgage for $200,000 and a $25,000 second mortgage. This type of financing saves you the cost of Private Mortgage Insurance which would be required if you were to use one mortgage for 90 percent of the purchase price.

Interest paid on a home mortgage, and property taxes, are tax deductible. So, as soon as you close on your new home you can adjust your income tax withholding. This gives you more cash to pay bills and to start saving for the next home. In time, your income may increase in which case you might pay off the second mortgage. This doubles your equity position from $25,000 to $50,000.

If your home appreciates 6 percent a year for 5 years, your property will be worth $334,556 at the end of the 5th year. By this time, you will have paid down your mortgage balance by over $10,000. So you'll have about $145,000 in equity. If your sell your home, you'll have to pay selling costs, but should still net $130,000 to $135,000 which can be used as a down payment on your next home.

First Time Homeowner Tip: If you refinance to pull cash out of your home, you could undermine your equity position.

Cash-out mortgages have become popular with American homeowners. They work like this. The value of your home goes up. A lender is willing to increase the size of your mortgage and give you the difference between the amount of your old mortgage and the amount of the new one in cash.

The Closing: Although it might seem like easy money, there are risks inherent in cash-out mortgages. The cash from your refinance is usually spent rather than saved for investing in your next home. And, if home values drop you could end up owing your lender more than your home is worth.