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Credit cards are convenient things. They mean we don’t have to carry cash around, and if we don’t have the cash for an important expense right now, we can put it on the card and pay it off over time if we have to.
Unfortunately, credit cards also make it easier to get into debt. Even if you’re being careful, one big expense can put you in a tough spot. The good news is there may be a way to make the debt more manageable by utilizing your home equity to do a debt consolidation at a lower interest rate than you would get on the credit card.
We’ll go over how a cash-out debt consolidation could help you get on better financial footing. Before that, let’s take a look at the scope of the problem.
How Much Debt Do We Have?
If you have credit card debt, you’re not alone. According to NerdWallet, the average American household carrying credit card debt has balances totaling $16,748. In 2016, those balances added up to $779 billion nationwide. The average consumer carrying a balance paid roughly $1,292 in interest per year.
It may seem like the easiest solution to this problem is to avoid putting anything on the credit card that you can’t afford to pay off. While this is solid advice in general, life isn’t always that simple.
The Federal Reserve conducts periodic surveys of U.S. households to determine their economic well-being. This statistic jumped out at me: Among those who said they had a major unexpected medical expense, the median out-of-pocket cost was $1,200, and the mean expense was $2,383. That’s a good chunk of change that not everybody has.
Let’s take a look at the cost over time.
Quantifying the Payments
In order to give an example of how much this could really add up to, I’m going to take the average credit card debt of $16,748. The average credit card rate as of this writing, according to Bankrate, is 16.28%. I’m going to assume a minimum monthly payment amount of 3% of the total balance.
If you’d like to put in your own numbers, there are a variety of online calculators.
In the above scenario, your minimum monthly payment would be $502.44. It would take you 21 years to pay off, and you would pay $13,583.69 in interest.
The numbers are staggering and can throw you for a loop if you spend any time thinking about it. Fortunately, there’s a resource many of us have that may help us climb out of the hole while spending less money on interest.
Using Your Home Equity to Consolidate Debt
If you have some untapped equity in your home, you can take a look at consolidating debt. We’ll go over how that works, but first, let’s give a quick primer on home equity.
The Equity Equation
You can think of equity as how close you are to owning your property outright. With each payment and each time your property value increases, you’re gaining more equity in your home.
The amount of equity you have in your home is measured by your loan-to-value (LTV) ratio. Let’s say you bought a home for a purchase price of $100,000. You had a 5% down payment, which means you start out with a 95% LTV. Over the next few years, you pay down the principal on the loan to $87,000. Meanwhile, your appraised property value has increased to $110,000.
To find your LTV, you take the unpaid principal balance and divide by the current value of your home. In the above example, your current LTV would be about 71%.
The reason this number is important is you have to have a certain amount of equity in order to take cash out. The amount you need depends on the number of units in the property, whether the loan is fixed or adjustable, and who backs the loan (Fannie Mae, Freddie Mac, the FHA, etc.).
When you do a cash-out refinance, the major mortgage investors will require you to leave a certain amount of equity in the property. This is important because if the maximum LTV is in the range of 80% to 85%, you’ll have to make sure that removing the equity still gives you enough money to accomplish your goals. For those eligible for a VA loan, it is possible to take out a loan for the full appraised value of your home, but you need a conforming loan amount and 680 median FICO score. Now that we’ve gone over how equity works, let’s get down to business.
Tackling Your Debt
In debt consolidation, you use the proceeds from a cash-out refinance in order to pay off any existing debts. Up to this point, we’ve discussed high-interest credit cards, but it could be used to pay off things like student or personal loans as well.
You’re essentially paying off any existing balances and transferring them to your mortgage. However, you’ll be paying a much lower rate of interest. The average rate on a 15-year fixed mortgage, as of this writing, is 3.5%, according to Freddie Mac.
Let’s say you had $133,000 left on your mortgage balance. If you took $17,000 worth of equity out of your home to pay off credit card debt, you would have a $150,000 mortgage. You would pay about $43,000 in interest on the entire mortgage at a rate of 3.5%.
What’s really cool about this, though, is that we’ve been able to roll the credit card debt in at a much lower interest rate. Instead of paying almost $13,600 at the credit card rates mentioned above, the interest you’re paying on the $17,000 you took out of your home is actually closer to $4,900.
If you want to experiment with how much you could save, check out our amortization calculator. There’s no reason to keep carrying high-interest debt if you can help it.
Do you like what you’re reading? You can go ahead and 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.
Do you have questions? Maybe you have success stories about all the things you were able to accomplish by consolidating debt. Share in the comments.
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