A home is supposed to be a piggy bank. Every payment you make on your mortgage reduces your debt, which adds to your savings. You’re aiming to own your home free and clear by the time you retire.

But lately, many homes have morphed into credit cards. When you need extra money; that’s where you look for a cash advance. The temptation becomes especially great when you refinance your mortgage, which many of us do when interest rates drop. As you’re signing those papers, it seems soooo easy to borrow more.

Which is why people generally aren’t exactly rolling in home equity. When real estate prices go up, we should be fat and happy. But as fast as some people get a little equity, they’re borrowing it out. Many of us are tapping our homes for consumer spending, and the banks are egging us on. When you refinance, some banks will lend you more than 100 percent of the value of your house (at a higher interest rate, of course!).

Borrowing more against your home is called cash-out refinancing. You start with, say, a $200,000 loan and replace it with one for $225,000. Traditionally; people tapped their home equity only for big-league expenses such as college tuition or a major renovation. Today you might use the money to pay off high-interest credit card debt. That sounds practical, until you realize that you’ve just spent your home equity on stuff. With cash-outs, some of the money usually leaks into new purchases as well, such as vacations, a big-screen TV, or whatever. I’d recommend cash-outs for credit card debt only if you have your spending under control. To me, that means getting through one full year without adding to your consumer debt.

Is it ever a smart move to refinance? Sure, as long as your goal is to take advantage of lower interest rates rather than to fill the house with more goodies. Find out first what your closing costs will be–those up-front mortgage fees, attorneys’ bills, taxes, and so on. They can run from about $1,000 to $5,000. A new loan typically makes sense if the amount you’ll be saving covers those costs within three or four years. (If you borrow to cover the fees, as most people do, don’t forget to include the extra interest expense in your calculations. Also, be sure there’s no prepayment penalty. If you need the help you can download a free budget planner tool from our website.)

There are two ways to save with a refinancing. You can use the lower mortgage rate to reduce your monthly payments. That’s the popular choice. But you’ll gain far more by reducing the term of your mortgage–say, from a 30-year loan to a 20-year or even a 15-year loan. True, with a shorter term, you might pay a little more each month (even with a lower interest rate), but a larger amount of each payment will go toward reducing your loan principal.

The differences can be astonishing. To see for yourself, ask the lender to calculate your interest savings over various periods of time.

Whichever way you go (lower payments or shorter term), don’t borrow more than 80 percent of the value of your home (60 percent if you’re over age 45). As an investment, building equity is what real estate is all about.

Be $23,987 richer in ten years

Suppose you have a $150,000, 30-year loan at 8 percent. And suppose you refinance at 7 percent for a 20-year term, paying an extra $62 a month. If you sell your house ten years later, you’ll save $23,987 in direct interest payments alone. Here’s the amazing amount you’ll gain overall.

Extra equity after the sale     $31,427

Total extra monthly payments    -$7,440

Your big gain                   $23,987

Have anything to add? Let me know in the comments.

Thanks to Money Wise Pastor for featuring this article.