How to consolidate debt with mortgage refinance
Managing multiple debts can be challenging. You must keep track of multiple due dates and pay each debt on time to avoid additional interest, fees and penalties.
Homeowners have an advantage when it comes to dealing with several debts, though. They can leverage their home equity to refinance their mortgage and consolidate debts. If you refinance your mortgage, you could use it as an opportunity to consolidate debt, streamlining your debt management with a single loan.
What is debt consolidation?
Debt consolidation is the process of using one loan to pay off multiple debts. By consolidating your debts, you effectively combine several debts into a single debt source and single monthly payment. The new loan typically has a lower overall interest rate.
You can consolidate debt with either a loan — such as a cash-out mortgage refinance — or by transferring balances to a low-interest credit card.
First, you must identify which debts you’d like to consolidate. From there, you seek out a loan large enough to pay off all those debts. Once you apply and get approved, your lender will disburse funds to you to pay off your loans. Alternatively, some lenders send your proceeds directly to your creditors. Then, you begin repaying this new loan.
Consolidate debt by refinancing your mortgage
You can use cash from a cash-out refinance to pay off high-interest debt, then pay the money back at a lower interest rate.
Homeowners don’t always pay off their first mortgage entirely. Instead, many refinance their mortgages, meaning they take out a new mortgage to lower their interest rate, change the loan term or get cash from the equity they’ve built up.
There are two main types of mortgage refinancing. A rate-and-term refinance allows you to replace your current mortgage with a new one at a lower rate, a different term or both. This can help lower your monthly payment. Rate-and-term refinancing loans are also helpful for switching to a different mortgage product. For example, if you currently have an adjustable-rate mortgage and you need more stability, you can refinance into a more stable 30-year fixed mortgage.
However, rate-and-term refinance loans don’t let you consolidate because you take out only enough to pay off your old mortgage balance. There’s nothing left for other debts, such as credit cards or student loans. If you have significant equity in your home but juggle several nonmortgage debts, a cash-out refinance might be a better choice.
A cash-out refinance lets you take out a new mortgage that’s greater than your current balance. In doing so, you effectively convert some of your equity to cash, which you can then use to pay off high-interest debt. For example, if you have $80,000 left on your mortgage balance, and you do a $90,000 cash-out refinance, you get $10,000 in cash to consolidate other debts.
Cash-out refinances come with slightly higher rates than rate-and-term refinances because you’re taking out more money. Therefore, comparison shopping for the best rates is vital.
You also have to look at the interest rates on all debts you plan to consolidate and calculate the average interest rate, giving more consideration to higher debt amounts. Once you know the average interest rate you’re paying on the debts you want to consolidate, you simply need to make sure the refinancing loan’s rate is lower.
Pros and cons of refinancing
Before refinancing a mortgage to consolidate debt, you should think about the advantages and disadvantages.
What are the benefits of refinancing debt?
- Fewer monthly payments: Consolidating multiple debts into one makes it easier to keep track of your monthly payments. You’re less likely to forget a payment and incur late fees or penalties. It’s also easier psychologically to deal with fewer debts.
- Lower interest rate: Mortgage refinance loans have much lower interest rates than most other debts. Consolidating via a mortgage refinance can save you thousands on interest if the new rate is less than the weighted average rate of the old debts.
- Defined maturity date: Credit card debt can be tough to pay off with no fixed end date. Turning your credit card debt into a mortgage refinance loan provides you with a defined maturity date.
- Possible tax benefits: By converting your debts into a new cash-out refinancing loan, you may be able to take advantage of mortgage interest tax deductions, which aren’t afforded to those with consumer debts (like from credit cards and personal loans).
What are the drawbacks to refinancing debt?
- Debt restart: Unless you’re refinancing from a 30-year mortgage to a 15-year mortgage, you’re restarting your debt. Your monthly payments and interest may be lower, but you now have much longer before you own your home outright.
- Credit and debt-to-income requirements: Getting the best rates and terms on refinancing loans requires a strong credit history and a low debt-to-income ratio, especially for cash-out refinance loans. If you have a lot of debts and your score has taken some damage, you may struggle to find a suitable refinancing loan.
- Risk of foreclosure: Mortgages always come with the risk you lose your home. Getting too big of a refinancing loan — such as a cash-out refinance — may result in difficulty with repayment, which can increase your risk of defaulting and losing your home.
- Extra fees: The process of refinancing a mortgage is much the same as getting a new one, especially when it comes to closing fees. Some fees include application fees, origination fees and appraisal fees.
Is refinancing worth it for debt consolidation?
If you have a number of high-interest debts that you’re struggling to repay, consolidating them with a cash-out refinance can streamline your finances and reduce your chances of late or missed payments.
However, cash-out refinancing involves taking out more money than your current mortgage balance. This and higher interest rates compared with rate-and-term refinancing lead to a higher monthly payment, so it’s important to make sure you can afford the new amount. Cash-out refinances also require a higher credit score and a better debt-to-income ratio.
Make sure you look closely at your debts and your home equity, then shop around before moving forward with a refinancing loan for debt consolidation.
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