If you’re feeling overwhelmed by debt, you’re not alone. Many American households are dealing with major credit card debt on top of mortgages, student loans, car loans and medical bills. According to NerdWallet, American households carrying credit card debt have an average balance of $15,561. In 2018, those balances added up to $944 billion nationwide.
With some of the highest interest rates of any debt, credit card debt is one of the worst to carry. In fact, consumers pay double or even triple the interest rates on credit cards than they do on most auto loans, student loans and home loans.
For homeowners, the good news is there may be a way to make the debt more manageable by refinancing your mortgage. A mortgage refinance can help you consolidate your debt by capitalizing on low mortgage interest rates while tapping into your home’s equity.
How a Mortgage Refinance Can Help You Pay Off Your Debt
A cash-out refinance is one type of mortgage refinance that will allow you to consolidate your debt. This process involves borrowing money from the equity you have in your home and using it to pay off other debts, like credit cards, student loans, car loans and medical bills. Essentially, you’re paying off any existing balances by transferring them to your mortgage. This places all the balances into one debt, so you’ll only have to make one monthly payment. The greatest benefit is that you will only pay one, much lower interest rate.
Let’s look at an example of this using credit card debt.
According to Bankrate®, the average credit card interest rate is 17.78%. With this interest rate, it would take you about 25 years to pay off a credit balance of $15,561 (the national household average), assuming you only pay the minimum payment of 3% of the total balance ($466.83) each month. On top of that, you’d pay an additional $14,989.62 in interest over that period of time.
On the other hand, the average interest rate on a 15-year fixed mortgage is 3.5%– that’s 14% lower than the average credit card rate.
In the scenario above, you could take $16,000 out of your home equity to pay that credit debt off immediately. The $16,000 would then be added to your mortgage, which has an interest rate of 3.5%. With that interest rate, you would pay $4,600 in interest instead of almost $15,000. A cash-out refinance would save you more than $10,000 on that $16,000 worth of debt.
Should You Refinance Your Mortgage to Consolidate Debt?
Like any financial decision, you’ll want to do your research and consider all of your options. When determining if a cash-out refinance is best for you, ask yourself the following questions.
Do I have enough equity?
Since you’ll be using the equity in your home, you’ll need to have enough to borrow while keeping some remaining in the home – a requirement of most mortgage investors. The amount of equity you leave in your home after you refinance is important because it affects your loan-to-value (LTV)ratio. Your LTV determines whether you need private mortgage insurance, or PMI, which can cost you hundreds on your mortgage payment each month. If your LTV is higher than 80%, your lender may require you to pay this insurance.
To avoid paying for private mortgage insurance, your LTV after you refinance needs to be at 80% or lower. If you have to pay PMI each month, a cash-out refinance may be counterproductive.
To see how a cash-out refinance could affect your LTV, follow the formulas below to calculate your numbers and compare.
To calculate your LTV before refinancing, divide your loan balance by the appraised value of your property. The formula looks like this:
Loan Balance/Appraised Property Value = LTV
Let’s say your home is worth $200,000 and your loan balance is $140,000. Your LTV would be 70%.
Property Value = $200,000
Loan balance = $140,000
140,000/200,000 = 0.70
To figure out how much your LTV would be with a cash-out refinance, simply add the amount of equity you want to borrow to your current loan balance, then divide that by the appraised value of your property. The formula looks like this:
(Equity Borrowed + Current Loan Balance)/Appraised Property Value = LTV
Using the example above, we’ll add on that $16,000 you would borrow to pay off your credit card debt. Your new loan balance would be $156,000 and your new LTV after your cash-out refinance would be 78%.
Property Value = $200,000
Loan balance = $140,000
Cash-out amount borrowed = $16,000
New loan balance – $156,000
156,000/200,000 = 0.78
With a 78% LTV, you could do a cash-out refinance with enough equity leftover to avoid PMI.
Use this formula to calculate what your LTV would be after a refinance. If it’s higher than 80%, you may want to seriously consider whether taking out that equity would give you enough money to accomplish your goals.
The only exclusion to the LTV requirement is the VA loan. If you are eligible to receive a VA loan, you could refinance up to 100% of the equity in your home. However, you must meet specific qualifications to do so.
Can I afford a higher monthly mortgage payment?
Refinancing doesn’t get rid of the debt. It transfers it over to another debt – your mortgage. When you refinance, your mortgage balance will increase by the amount of equity you borrowed. So, for example, if you borrowed $16,000 from your equity to pay off your credit debt, your mortgage balance will go up by $16,000.
No matter how much debt you transfer, increasing your mortgage balance will increase your monthly mortgage payment. And depending on the terms of your refinance, the new loan could raise your monthly payment by a few dollars to a few hundred dollars.
Keep this in mind when you’re considering your budget and financial goals. Will you be able to afford a higher mortgage payment? If you’re having trouble making your monthly payments now, a refinance may not help. It could even put you at risk of foreclosing on your home
Does the cost of the mortgage make sense compared to other options?
Just as you would on an original mortgage, you’ll need to pay closing costs on a mortgage refinance. Underwriting and origination fees are common closing costs associated with a refinance. Some additional costs may include an application fee, appraisal fee and attorney review fee. The total closing costs of a refinance will depend on the amount you borrow, where you live and the lender you choose.
If the cost of a mortgage refinance is too high, another option to consider is using a personal loan to consolidate debt. A personal loan may be a better fit for your financial goals if:
- You want to keep your equity or don’t have enough equity to refinance.
- You want to take out a smaller loan amount.
- You want to avoid higher closing costs.
Though closing costs may be significantly lower, the tradeoff is that you’ll be paying a higher interest rate than a refinance, though not as high as credit card interest rates. You also won’t get the potential tax benefits as a mortgage refinance, which includes the ability to deduct mortgage interest.
If you think a mortgage refinance might be the debt consolidation solution you’re searching for, you can get a full refinance approval online through Rocket Mortgage®. If you would prefer to speak with one of our friendly and knowledgeable Home Loan Experts, we would be happy to take your call at (800) 785-4788. With any big financial decision, you should speak with a financial advisor who understands your individual needs and financial goals.
Do you have questions? Have you had success with consolidating debt? Share in the comments below.
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