Many homeowners use cash-out refinancing to consolidate other debts, including vehicle loans, credit cards and student loans. But before you go down that path, there are a few important things to ponder.
What is a cash-out refinance?
A cash-out refinance differs from a traditional refinance in that you aren’t just refinancing your existing mortgage to take advantage of a lower interest rate. Instead, your new mortgage is for a larger amount than your current home loan. Proceeds from the refinance loan are first used to pay off your existing mortgage, plus closing costs for the new loan. You receive the excess amount in cash.
Obviously, the amount you can borrow depends partly on how much equity you have. Your home equity is the difference between the value of your home, and your current mortgage balance. The amount you can borrow depends on loan-to-value (LTV) ratio limitations. The LTV ratio is simply the amount of the mortgage, divided by the property’s current market value.
LTV limits vary based on the type of loan you apply for:
- Conventional loan: 80%
- Federal Housing Administration (FHA) loan: 85%
- Veterans Affairs (VA) loan: 100%
Paying off debt with cash-out refinancing
Most homeowners have a variety of debts; mortgages, credit cards, auto loans, and student loans. Doing a cash-out refinance won’t reduce the amount of debt you owe, but it can help you save on interest and perhaps lower your monthly payments.
This is because interest rates on mortgages are typically much lower than those for credit cards. For example, as of April 4, 2019, the U.S. weekly average for a 30-year fixed rate mortgage was 4.08%. But the average credit card interest rate for the same week was 17.85%.
Proceed with caution
Keep in mind that although your interest rate may be lower with a refinance, you’re not lowering your total debt load. In fact, you’re probably increasing it by the amount of the closing costs that were included in the new loan. Plus, you’ve extended the length of time it will take to pay off that debt.
Also, income tax rules regarding mortgage interest deductions change frequently. If you have any questions or concerns regarding the deductibility of mortgage interest, be sure to consult with a tax professional before committing yourself to any type of loan.
We can help
Evaluating your debt consolidation options can get real confusing in a hurry. There are a lot of variables and scenarios that need to be carefully considered. To complicate things, there’s a bunch of misinformation and just plain bad advice out there. If you’d like to speak with some smart folks who can clear away the jargon and explain the alternatives in simple terms, you’ve come to the right place.
Debt consolidation alternatives
Before you delve into a cash-out refinance to pay off your debts, be sure to consider all of your options.
Personal loans may be a good option for debt consolidation because they generally come with shorter terms than mortgages. If you can secure a low interest rate, you might be able to pay off your debt faster than you would carrying the same balance on a credit card. Also, personal loans are typically unsecured, so if you have trouble making payments, your home won’t be at risk.
Home equity line of credit
A home equity line of credit (HELOC) is a revolving loan that uses your home as collateral. This may be a good option for consolidating other high-interest debt because the interest rate is typically lower than those charged on a credit card. However, most HELOCs are adjustable-rate loans, meaning if interest rates go up, your monthly payment and the cost of borrowing will go up.
Home equity loan
A home equity loan is similar to a HELOC in that you borrow against your home’s equity. However, unlike a HELOC, a home equity loan gives you a lump sum in advance and you repay it in fixed monthly installments. Plus, home equity loans are generally fixed-rate loans.
Cash-out refinancing might make sense if you can lower your monthly payments, pay off high-interest debt and avoid taking on more debt after the refinance. But it may not be your best option — If you’re unable to make your monthly mortgage payments, you could lose your home.
In conclusion, don’t just look at the amount you’ll save by lowering your total monthly payments. Also consider the effect a reduction in home equity and a longer mortgage term will have on your overall financial future.