Debt consolidation through a refinanced mortgage is an attractive and beneficial way to pay off loans and eliminate high-interest debt. The prime factor for qualifying for debt consolidation refinancing is based on the equity in your home – which is the appraised value of your home less what you owe on the mortgage.
A debt consolidation loan allows the borrower to use a single, lower-interest loan acquired through refinancing to pay unsecured debt like credit cards, student loans and medical bills as well as the mortgage. With interest rates so low in early 2021, the new loan could keep the monthly payment on that unsecured debt close to the same, or even lower than what a consumer was paying. An added benefit: Unlike credit card interest, the interest on a refinanced loan is tax deductible.
Can You Refinance to Pay Off Debt?
If you have sufficient equity in your home, refinancing an existing mortgage to pay off debts is considered a solid financial strategy. Refinancing simply means taking out a new mortgage on your home. The new loan pays off the old mortgage and allows the opportunity for the borrower to receive extra money – cash out is the term used – that can be used to pay other debts. This approach could allow borrowers to free themselves from the high interest rates charged by credit cards.
Refinancing a mortgage for debt consolidation is not free, though. Closing costs for a new loan could include an application fee, origination fee and cost for an appraisal, among others, with total costs ranging between 2%-to-5% of the loan. It’s wise to check all closing costs carefully and make sure the costs are not more than the total interest costs you would be paying on the credit card debt.
Qualifying for refinancing depends on the equity in the home. Refinancing loans typically limit the amount borrowed to 80% of the value of the home, though in some rare cases lenders may go as high as 90-to-95%.
Consider a home appraised at $200,000; 80% of that would be $160,000, which means the mortgage being refinanced must be less than $160,000. That means the borrower must have at least $40,000 in equity in the home. Other factors lenders will consider before the loan is approved include credit history, income, job history, debts and assets.
A few options are available to borrowers looking to refinance to deal with debt. The most common is cash out, which allows borrowers to use the equity in the home to acquire extra money that can be used to pay other debts. Other options include a Rate & Term Refinance, and a home equity line of credit.
Those with significant debts other than the mortgage may find a cash-out refinance the most attractive option – if they have sufficient equity in the home. Consider an example for refinancing a home loan to consolidate debt where the home is valued at $200,000 and $100,000 remains on the mortgage. That means there is $100,000 in equity in the home, plenty to refinance. With an 80% loan-to-value limit, the borrower could refinance for up to $160,000.
If the borrower has $25,000 in credit card debt, he or she can refinance for $125,000. The lender pays off the $100,000 mortgage, then either directly pays the credit card debt or provides $25,000 in cash for the borrower to pay off credit cards. The borrower is left with one monthly mortgage payment. A cash-out loan requires good credit and a history of timely payments. Borrowing more than 80% of the value of the home also may require private mortgage insurance. This kind of loan is a good way to reduce overall debt, but study the interest rate to see how It affects the monthly payment, and if it’s affordable.
Rate & Term Refinance
A rate and term refinance changes the loan term and/or interest rate, and is an option for those who are having trouble making monthly mortgage payments. Often the refinancing of the rate or term can be accomplished without a credit check or new appraisal.
Consider a mortgage of $150,000 at an interest rate of 4% over 30 years. The payment on that loan would be $716 per month. If the interest rate could be reduced to 3%, the payment would drop to $632. If the $150,000 loan was originally at a 15-year term, extending the term to 30 years would reduce the payment from $1,110 per month to $716. The extra cash would be a short-term help, but over the course of the loan, a lot more money would be paid in interest.
Home Equity Line of Credit
A home equity line of credit, typically known as a HELOC, is not a refinance but is a way to borrow against the equity in the home. If a borrower has $50,000 in equity, he or she could establish a home equity line of credit for $50,000 and use that money to pay other debts. This option is best for those who already have an affordable mortgage at a good interest rate.
A HELOC acts like a credit card — without the high interest rates. Consumers can borrow up to the value of the open credit line (in our example up to $50,000), and interest is only charged on money actually used . Money from the HELOC could be used for expensive home repairs, a vacation, education a new car and many other things. The interest also can be written off at tax time.
Is Refinancing to Consolidate Debt a Good Idea?
Refinancing is a great way to reduce debt, but only works if the borrower plans to budget for reduced spending in the future. It makes little sense to pay off one credit card, then max out another a month later. The loan’s success is only as dependable as the financial discipline of the borrower.
Keep in mind that refinancing some loans can increase the monthly mortgage payment even while reducing total overall debt. In the long run, total money paid in interest could increase. And the price of closing costs cannot be ignored. However, with careful planning and discipline, a refinance can be a help to consumers who want to use this loan to eliminate high-interest credit card debt.
About The Author
Max Fay has been writing about personal finance for Debt.org for the past five years. His expertise is in student loans, credit cards and mortgages. Max inherited a genetic predisposition to being tight with his money and free with financial advice. He was published in every major newspaper in Florida while working his way through Florida State University. He can be reached at [email protected].
- Martin, Erik J. (2021, January 15) Debt consolidation refinance: How it works, pros and cons. Retrieved from https://themortgagereports.com/34032/debt-consolidation-refinance
- Luthi, B. (2020, July 17) Should I Do a Cash-Out Refinance to Pay Off Debt? Retrieved from https://www.experian.com/blogs/ask-experian/should-i-do-a-cash-out-refinance-to-pay-off-debt/
- Treece, K. (2021, February 2) What Is Debt Consolidation & How Does It Work? Retrieved from https://www.forbes.com/advisor/personal-loans/what-is-debt-consolidation/