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Refinance To Pay Off Debt: Is It Right For You?

Your home often serves as the bedrock for you and your family: it’s a refuge, a place to gather, and a way to find stability. It also builds equity as you pay your mortgage and accrues more value through appreciation. If you’ve paid off a significant chunk of your mortgage, you can refinance to consolidate debt, taking on a larger mortgage in return for a potentially more manageable way to handle debt.

While mortgage interest rates have followed the national trend, other forms of debt have received elevated rates as well. This overall change means that refinancing remains a viable tool for consolidating high-interest debt like credit cards into one, lower-interest payment. However, the associated costs, including insurance premiums and closing costs, require borrowers to carefully evaluate their circumstances to determine if refinancing is the best way forward. 

Can You Refinance To Consolidate Debt?

Refinancing a mortgage to consolidate other debts is for homeowners with sufficient equity. This option lets you turn your home equity into cash (through a cash-out refinance) or get a new mortgage (through a rate and term refinance) with a new monthly payment. The refinance could provide financial assistance for consolidating debt you're struggling with, including student loans, credit card debt and personal loans. 

Paying off debt through a cash-out refinance means evaluating your financial circumstances first. The following aspects must align to make refinancing a sound choice:

Sufficient home equity: Lenders typically require borrowers to have 20% equity in their home to qualify for a cash-out refinance. Equity is the difference between the current market value of your home and the outstanding balance on your mortgage. If the borrower low equity, the financial benefit isn't significant enough for the borrower, and lenders won't approve the loan. You can determine your equity by calculating your loan-to-value ratio (LTV). This term is a percentage expressing your mortgage balance versus your home's market value. For example, say you have a $200,000 mortgage. Your home appraises for $300,000. Therefore, 200,000/300,000=0.66, or 66%. Your loan is worth 66% of your home, meaning you have 34% equity.

Understanding your LTV is crucial because it provides a benchmark for your loan. Lenders typically limit a cash-out refinance to push your LTV to the 80%-90% range. Using the example above, this policy means your new mortgage will likely be $270,000 at most. So, your refinance would provide about $70,000 for paying off debt, and you would have a new mortgage of $270,000. 

Also, because the refinance would put you above 80% LTV, you would pay private mortgage insurance (PMI). PMI increases your monthly mortgage payment until you attain 20% equity. Factoring in this additional cost is critical to understanding if a refinance is financially advantageous.

Interest rates: One of the essential benefits of consolidating or repaying debt with are finance is the interest rate on the new mortgage. Because mortgages usually have some of the lowest interest rates among loan types, refinancingcan be one of themost affordable ways to borrow money. For instance, the APR for a credit card canbe three times or more than the average mortgage rate. When evaluating your finances, you’ll want to make sure you understand the impact of reducing the interest rate of your other debts by consolidating and whether it will be worth the closing costs associated with a refinance.

Should You Refinance Your Mortgage To Consolidate Debt?
Whether you should refinance your mortgage to consolidate debt depends on your financial situation. Other than your equity and interest rate, several key considerations will affect your decision. First, your credit score and debt-to-income ratio (DTI) are determiningfactors in qualifyingfor a loan and receiving a low interest rate. Specifically, a credit scoreof 620 and a DTI below 50% are thresholds for refinance eligibility. You likely won’t qualify for a loan if you don’t meet those requirements. Likewise, excellent numbers in these areas can help you obtain better rates.

Secondly, your appraisal provides the benchmark for how much you can refinance. For example, having $100,000 left on your mortgage doesn’t guarantee a refinance. If yourhome appraises for $120,000, your LTV is 83%, meaning you don’t have enough equity for a lender to approve a new mortgage. On the other hand, the same loan amountwith a homethat appraises for $300,000 means your LTV is 33%, giving you ample equity to tap.PMI also comes intoplay if refinancing causes you to exceed 80% LTV. This factor costs between 0.2% to 2% of your loan amount every year. For example, a $150,000 loancouldincur a maximum of $250 PMI per month. As a result, PMI and interest costs could combine to make refinancing more expensive than your monthly debt payments.

Lastly, closing costs apply to refinances and new mortgages alike. Closing costs include originating the loan, getting an appraisal and paying an application fee. Altogether, closing costs range from 2% to 6% of your loan amount. Therefore, closing on a $150,000 refinance could cost up to $9,000. Your lender will subtract this cost from the lump sum you receive. In a rate and term refinance, the borrower may have to pay it upfront or roll it into the loan amount. In either case, it’s vital to figure the cost into the bigger picture.

Refinance Calculator

As you can see, a hefty amount of math is required when evaluating loan costs for a refinance. Fortunately,the Rocket Mortgage® refinance calculator crunches the numbers for you, giving you the results ofgetting a new loan versus keeping your current debts. It can show you whether lowering your monthlypayment or cashing out your equity is the right move.

Mortgage Refinance Options to Consolidate Debt

Refinancing gives three main options for paying off debt. While equity allows you to knock out large debtbalances, you can also adjust the costs of your current mortgage balance to provide a financial benefit. Here are the details:

Cash-Out Refinance

A cash-out refinance means converting part of your equity to cash. For example, if you have a $200,000mortgage and a $300,000 home, you could refinance for a $250,000 mortgage, giving yourself $50,000 toconsolidate debts. This tool transfers your debts to your mortgage, allowing you to take advantage of the low interest rates mortgages receive. However, it’s essential to have a stable income and a strong creditscore to qualify. For instance, Rocket Mortgage offers cash-out refinances to borrowers with a median FICO® Score of 620 or higher.

Remember, the drastic difference in interest rates among forms of debt can work to your advantage here.Converting a $10,000 credit card balance with a 25% APR to your mortgage balance with an 8% interest ratecan reduce interest charges by hundreds of dollars per month.

However, cash-out refinances have their drawbacks. First, increasing your mortgage loan size meansextending the life of the loan. Adding years to your mortgage means risking default for longer than the originalloan. Falling behind on payments means you could lose your home.

Additionally, mortgage insurance costs can be prohibitive, as shown in the refinancing example above. PMIcan add hundreds of dollars per year to your mortgage, making the refinance as expensive as your outstanding debts.

Rate and Term Refinance

A rate and term refinance means the refinance lender pays off your original mortgage and issues a new onewith an updated rate and term. Getting a new rate in today’s market may raise your interest from its previouslevel. However, you can lower your monthly payment by obtaining a longer term along with the higher rate.While your mortgage interest costs may increase, by lengthening the amount of time you have to pay off yourloan, you may decrease your mortgage payment. Diverting hundreds of dollars from your mortgage paymentto other debts can be an efficient way to pay down outstanding balances.

For example, say you have $100,000 left on your mortgage. While interest rates have been high for the last fewyears, you can refinance this amount into a new 30-year loan. Doing so can reduce your monthly payment byhundreds of dollars. The tradeoff is higher interest costs in the long run. However, trading a debt with 20%interest for an equivalent debt with 10% could make a difference.

That being said, similar risks of a cash-out refinance apply to rate and term refinancing. You’ll pay closingcosts, you’ll need to meet specific financial criteria, and the mortgage will persist for more years than theoriginal. Furthermore, you may give up a lower interest rate you received years ago.

Government-Backed Mortgage Refinance

Government-backed mortgage refinances are also available for qualifying borrowers. For instance, the FHA cash-out refinance can help borrowers with credit scores of 580. The downside is that you’ll pay the government’s form of mortgage insurance, known as mortgage insurance premiums (MIP).

Alternative Ways to Consolidate Debt

Borrowers can also take advantage of alternative methods for debt repayment that don’t involve a refinance.Depending on your circumstances, these options provide different benefits and may be more suitable.

For example, a personal loan can play the same role as a cash-out refinance. However, instead of using yourhome to secure new debt, you can acquire an unsecured loan or secure it with other property, such as acar. Unsecured personal loans have higher interest rates, while secured personal loans risk your collateral.Additionally, personal loans have origination fees, increasing their financial burden.

However, these loans usually have lower interest rates than credit card rates, so paying off a credit card with apersonal loan can provide some financial relief. With consolidation with a personal loan, you roll several debtsinto one loan with a favorable interest rate to reduce expenses and simplify debt management.

On the other hand, some credit card companies offer balance transfer cards with 0% introductory APR. No interest during the promotional period (typically 12-18 months) allows you to focus on paying down theprincipal. These cards usually charge a balance transfer fee of 3%, which you can look at as a nominal origination fee or closing cost for an interest-free loan. If you can pay the balance before the introductory rateexpires, you will pay zero interest charges, making for an efficient method for handling debt. However, the APR afterward will likely be above 20%, so any remaining balance will incur heavy charges. Lastly, your 401(k)is a source you can draw upon for debt relief. Withdrawing from your 401(k) will incur income taxes, and you’llpay a 10% early withdrawal fee if you’re under age 59 ½. If you have a Roth 401(k), you won’t pay incometaxes if the account is at least 5 years old. The disadvantages are the applicable taxes and fees. Plus,shrinking your retirement account means you’ll have to work longer or take on a lower standard of livingduring retirement. Therefore, comparing these costs to the interest on your outstanding loans is crucialbefore taking this route. You should also consult your plan administrator to make sure this option is even offered.

No matter what plan you choose to consolidate or even pay off your debt, it is recommended that you speak to a financial advisor.

The Bottom Line

Refinancing your mortgage to consolidate debt can be a savvy move if you can reduce your interestrate and monthly payments, giving yourself more capacity to address your outstanding loans. Borrowers cantap their equity, change their loan terms, and use government-backed mortgages to transform their home loans into debt consolidation tools to save money over the long haul. However, refinancing involves closingcosts, insurance premiums, and possible interest rate increases. It also relies on having a low enough LTV to qualify.

As a result, it’s advisable for borrowers to explore all their debt repayment options, including personal loans,0% APR credit cards, and 401(k) distributions, before refinancing. Remember, the goal is to repay yourdebts while incurring as few expenses as possible.

Ashley Kilroy

Original Publish Date: 12/19/2023

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