What To Consider When Using A Mortgage Refinance To Pay Off Debt
If you’re feeling overwhelmed by debt, you’re not alone. Many Americans are dealing with major credit card debt on top of mortgages, student loans, car loans and medical bills.
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 that they do on most auto loans, student loans and home loans.
For homeowners, the good news is there may be a way to help you better manage your finances by using a mortgage refinance to pay off debt.
Can You Refinance A Mortgage To Pay Off Debt?
A cash-out refinance can help you consolidate your debt by capitalizing on low mortgage interest rates while tapping into your home’s equity. Because mortgage rates are typically lower than other loans or lines of credit, using a cash-out refinance to pay off debt may save you money.
For example, if you took $16,000 out of your home equity to pay your credit debt off immediately, the $16,000 would then be added to your mortgage. The average interest rate on a 15-year fixed mortgage is in the low 3% range – that’s significantly lower than the average credit card rate, which hovers between 15.56% and 22.87%.
The minimum payment on a credit card with that amount of debt would be $320 based on the calculator of a major credit card issuer. At the low end of the above interest rate range for credit cards, you’ll be paying $9,496 in interest, while at the high end, it could be as high as $32,294 in interest.
This won’t be totally realistic, because there are minimum loan amounts and you would be adding your credit card debt to your balance and refinancing your existing mortgage, but this is about interests savings on that debt.
Let’s say the current interest rate was 3.25% for a 15-year fixed. If you look at just the $16,000 in credit card debt, the monthly payment would be $112.43. However, let’s say you make at least one of the minimum credit card payment would be. You would only end up paying $1,217.95 in interest and the entire balance would be paid off in just over 4 years. Adding that amount onto your mortgage doesn’t sound too bad when compared to almost $33,000 in interest potentially.
Mortgage Refinance Options
When looking into a mortgage refinance, it’s important to know what type of options are available. While only a cash-out refinance will allow you to consolidate your debt, other refinancing options can help you save money to pay down your debt.
A cash-out refinance 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 at a much lower interest rate.
With a rate-and-term refinance, the balance of your original loan is paid off and a new loan is opened to secure a new interest rate or a new loan term. You will then make all your future payments to this new loan.
By doing this, you can get a lower interest rate, which will help you save money over time. With the extra money you save, you can pay off some of your higher-interest debts.
Qualifying government-insured mortgages may be eligible for either an FHA streamline refinance or a VA streamline refinance. With this option, a new appraisal is not required. This can help keep the closing costs down, making it an affordable consolidation option for those who qualify. Keep in mind that FHA and VA Streamline refinance options won’t let you consolidate debt into the loan. Instead, they help you lower your monthly payments, giving you access to more of your monthly income to pay down existing debts. You also need to be in an existing FHA or VA loan.
Should You Refinance Your Mortgage To Consolidate Debt?
Like any financial decision, you’ll want to do your research and consider all your options. When determining if a cash-out mortgage refinance is best for you, ask yourself the following questions.
Will I Qualify For A Mortgage Refinance?
To qualify for a mortgage refinance, you’ll need to meet the following criteria:
- A credit score above 620 (580 for VA loans or FHA loans for our clients who are paying off debt at the closing table)
- At least 20% equity in your home (excepting VA loans)
- A 50% or lower debt-to-income (DTI) ratio
- Enough money to cover the closing costs
- Proof of income
Do I Have Enough Equity?
Since you’ll be using the equity in your home for a cash-out refinance, you’ll need to have enough to borrow while keeping some equity remaining in the home. This is a requirement of most mortgage lenders.
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.
Recent changes mean that you also have a hard time taking cash out if you have an LTV higher than 80%. In most cases, only borrowers using a VA cash-out refinance loan will be able to take cash out with LTVs higher than 80%. This is because the VA loan program allows qualified borrowers to use the equity in their homes even if it’s less than 20%. For VA loans specifically, you can cash out all of your existing equity if your credit score is 620 or better. Otherwise, you need to have an LTV no higher than 90%.
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.
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. 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?
You’ll need to pay closing costs on a mortgage refinance, just like you did on your original mortgage. Underwriting and origination fees are common closing costs associated with a refinance, but they’re not the only ones you’ll have to pay. 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 you would by refinancing your mortgage, though it won’t be as high as credit card interest rates. You also won’t be able to deduct interest paid on that personal loan.
Our friends at Rocket Loans® can help you look into your personal loan options. 1
The Bottom Line: Know Your Individual Needs And Financial Goals Before You Refinance To Pay Off Debt
Making the decision to refinance a mortgage to pay off debt is a big step. With any big financial decision, you should speak with a financial advisor who understands your individual needs and financial goals. 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®. You can also give us a call at (888) 452-0335.
1 Rocket Mortgage, LLC, Rocket Homes Real Estate LLC, RockLoans Marketplace LLC (doing business as Rocket Loans), Rocket Auto LLC and Truebill Inc. are separate operating subsidiaries of Rocket Companies, Inc. (NYSE: RKT). Each company is a separate legal entity operated and managed through its own management and governance structure as required by its state of incorporation and applicable legal and regulatory requirements.