Using Real Estate to Take Control of Your Debt

If you have a load of unsecured debt, such as high credit card balances, your top priority should be to reduce it as much as possible, as soon as you can. The longer you have the debt, the more unnecessary interest you pay. Credit cards in particular come with some of the highest interest rates in the financial industry.

Getting rid of that expensive debt is a nice idea in theory, but finding the finances to do so can be difficult. If you’re a homeowner, one way you may be able to reduce your balances — or at least the rates you’re paying on them — is to utilize the equity in your home. You can do this by refinancing your existing mortgage, cash-out refinancing or taking out a home equity loan.

Refinancing Your Existing Mortgage

With mortgage interest rates at an all-time low, one option to help free up cash is to refinance your existing mortgage at a lower rate, reducing your monthly obligations. The money you save can be used to pay off other debt, such as credit cards, or set aside for an emergency.

Pros:

• A reduced interest rate will save you money over the life of the loan and free up vital cash.
• Refinancing can extend the length of the repayment schedule, further reducing your monthly obligation.

Cons:

• Refinancing costs money: There can be closing costs, points and origination fees, along with appraisals and surveys.
• Refinancing to extend repayment time means you’ll spend extra years in debt and paying interest.

Cash-Out Refinancing

Another popular strategy is to take out a new, larger mortgage that pays off the old one and leaves you with cash at closing to pay off your other bills. This option, known as a cash-out refinance, requires that you have sufficient equity in the property. Your equity is the difference between the market value of the property and how much you owe on it.

If your property is valued at $300,000, for example, and you owe $250,000 on your mortgage, you may be able to refinance the mortgage at the higher amount and take out the difference to pay off other debts.

Once you complete the refinancing process, you’ll owe only your primary mortgage lender instead of owing a number of third-party lenders and credit card companies. This is, in essence, a debt consolidation. You are pulling equity from a property to pay off many bills and cutting the number of creditors – and bills – that you have.

In addition to simplifying monthly payments, this technique has another major benefit: savings. Right now, you could be paying 15 percent interest on a credit card, as the national average is 14.83. It’s not uncommon to do a home-equity refinance for less than 5 percent, since the average rate on 30-year mortgage loans was 4.5 percent in 2011. That means that rolling your credit card debt into a mortgage will result in immediate monthly savings.

But cash-out refinancing also has one major downfall: By binding your unsecured debts to your home, you’ve compromised your home’s equity and have a higher risk of going “underwater” — having a house that is worth less than you owe the bank. Similarly, if you use a new mortgage to consolidate your debt and then fall behind on your mortgage payments, you can face foreclosure.

Pros:

• You’ll save money by reducing your interest rate.
• You’ll reduce the number of payments you need to make each month.
• Because mortgage interest can be deducted on your income taxes, you are essentially turning some of your non-deductible debt into a debt that can be deducted, which could lower the amount you pay in federal tax.
• You may be eligible for lower monthly payments by combining all your debts. This gives you the opportunity to save more of your income or put it toward paying off your mortgage sooner.

Cons:

• If the debts you are rolling into your new mortgage result from habitual overspending, you must change your ways or your financial situation could easily worsen again.
• Refinancing can cost between 3 percent and 5 percent of the loan’s principal, in addition to the costs associated with creating a new mortgage, such as application fees, an appraisal and a title search.
• When you cash out your equity, you own less of your home.  If the value of your home goes down, you risk being unable to sell it for the amount mortgaged.
• Turning credit card debt into a mortgage turns this money into a secured debt. That means you are tying an asset to the debt.
• Depending on how long your new repayment plan lasts, you may end up spending more in total interest costs over the course of the loan.

Home Equity Loans

An additional strategy used to help reduce debt is to apply for a home equity loan, also known as a second mortgage. If you have equity in your property, you can use it as collateral to secure another fixed-rate loan and pay off other debts.

Similar to a home equity loan is a Home Equity Line of Credit (HELOC). The difference is that a HELOC is a line of revolving credit with an adjustable interest rate, instead of a fixed-rate, lump-sum loan. The borrower can decide when to use this open-ended credit.

Pros:

• Once again, these options may have tax benefits.
• The interest rate is typically lower than those for an unsecured loan or credit card. The national average for a home equity loan is 6.36 percent as of early 2012, while the rate for a HELOC is 5.22 percent — both well below the average credit card.

Cons:

• A home-equity loan creates a lien against your property that reduces the owner’s home equity.
• If you fail to make the loan payments, you risk defaulting, which could lead to foreclosure and loss of your home. In this circumstance, a strategy aimed at strengthening your financial future could put your largest asset in jeopardy.

Taking Action

If you decide that any of these options could be right for you, take appropriate action to receive your new loan or updated mortgage.

Here are the steps to take:

1. Review your credit situation. Your credit must meet your lender’s requirements before you can successfully refinance your current mortgage. You may need a credit score of at least 720 in order to obtain a favorable rate.
2. Get a preliminary idea of your home’s value. Experts say you should have a minimum equity of 20 percent of your home’s value to refinance. Agents and real estate websites can give you a rough estimate of your home’s market value. Remember, however, that the appraiser’s value is the final word.
3. Find a bank that can work with you. Shop around to find a lender who understands your needs and can provide you with a fair interest rate. The lender should be accommodating, responsive and able to provide you with complete information about the application process before you go forward.