Cash-out refinancing to pay off debt: is it worth it?
Withdraw equity to pay off debts
Can You Use A Cash Out Refinance To Pay Off Debt? You bet! In fact, a survey in 2021 found that debt consolidation was the second most common reason for a cash out refinance.
Now could be an especially good time to start paying off home equity and debt. Equity increased nearly 30% between 2020 and 2021. And mortgage rates are still low.
This way, skilled homeowners could significantly reduce their debt payments and increase their monthly cash flow.
Check your eligibility to withdraw the refinancing. Start here (December 7th, 2021)
In this article (continue to …)
How to use a cash-out refinancing to pay off debt
The process for a cash out refinance is similar whether you are taking out a loan to pay off debts or for some other reason. The steps are:
- Calculate how much cash you will need – Don’t borrow more than necessary
- Think how much you can borrow – Lenders will not loan you all of your equity. Most require that you leave 20% of your equity untouched, which means that your refinance loan has a maximum loan-to-value ratio of 80%. But those with VA loans can sometimes refinance 100% of their equity
- Apply for your cash out refinancing – This is pretty much the same as when you applied for your original mortgage. Expect an assessment and a thorough study of your finances, including your credit history and credit reports. You will need to provide bank statements, tax documents, and any other supporting document the lender may ask for. Here is a Documentation checklist
- Continue to close – Once your mortgage application is approved, the lender will follow the final steps required to finalize your loan. You will have to read something and sign it
- Pay closing costs – The closing costs for the refinancing are usually 2-5% of the new loan amount. As a rule, you can include your up-front costs in the new loan balance if you wish. But they will be deducted from the amount of cash you get on graduation
- Funds received and debts paid – With a debt consolidation cash out refinance, the debt you have chosen to repay is paid off along with the mortgage being refinanced. Any funds remaining after the initial mortgage and additional debt has been paid off will be withdrawn from the escrow account by either wire transfer or check
When you make your application, let the lender know that you will be consolidating your debt. This can help your application rather than harm it.
You may be asked to provide up-to-date bank statements about your debts and how they will be paid once the escrow account is closed. Show that you thought this through by creating a summary of your debts, with the total amount owed roughly equal to the amount you are borrowing. If there is a difference, explain the reason with a letter explaining the payout.
The debts you have accumulated could indicate that you have had problems managing your finances. So also show that you are determined to take control of these once your existing debts are paid off.
You may agree to seek help from a credit counselor. Or, you can create a detailed household budget that shows where you can save. While these additional steps take time, it isn’t unreasonable to have to show why you won’t be in the same situation again in a few years.
Check your eligibility to withdraw the refinancing. Start here (December 7th, 2021)
Benefits of Using Home Ownership to Pay Off Debt
The goal of a debt consolidation cash out refinance is to reduce your monthly debt payments. And you do that by transferring that high-yield debt to your new mortgage, which should have a much lower interest rate.
The most common high-yield debt is credit cards. And CreditCards.com estimates the average rate at the time of writing was 16.13%.
In contrast, at the time of this writing, the average 30-year fixed-rate mortgage rate was 3.11%, according to Freddie Mac.
For example, let’s say you owe $ 40,000 in credit card balances. Your typical minimum payment is $ 1,200, or 3% of the balance. But let’s say you pay $ 1,300 a month to pay off your debt.
CreditCards.com’s calculator says it would take you 40 months to pay off this debt, and it would cost you about $ 12,000 in interest.
Say you paid it off with a withdrawal refinance. We assume that you have a 30-year fixed loan and use this to refinance. And that your current mortgage balance is $ 200,000 while your home is worth $ 400,000.
Finally, let’s assume that you are currently paying a mortgage rate of 4% while your new mortgage rate is 3.10%.
Now let’s calculate the numbers using a mortgage calculator. They currently pay $ 955 per month in principal and interest. Once you refinance, your mortgage balance will be $ 250,000 (your old balance of $ 200,000 + the $ 40,000 used to pay off your cards + let’s say $ 10,000 closing costs).
The lower mortgage rate on your withdrawal refinance means you’ll be paying $ 1,068 each month on your new home loan, just $ 113 more per month than before. And you no longer have to pay $ 1,200 per month for minimum card payments.
All in all, this means that you can save about $ 1,000 per month by adding your credit card debt to your new mortgage balance.
Because their interest rates are so high, credit card balances usually get the greatest return when you use a cash-out refinance to pay off debt. But other debts with relatively high interest rates can also provide worthwhile, but less dramatic, savings. So do your own numbers for auto loans, personal loans, and other loans.
Disadvantages of cash-out refinancing to pay off debt
The first thing to keep in mind about using cash out refinance to pay off debt is that you are not actually “paying” the debt. You have not reduced the total amount you owe. All you have to do is switch from one type of credit to another, lower-interest type of credit.
Of course, this strategy has great advantages (as shown above). By converting your high-yield debt into a low-interest mortgage balance, you can potentially save a huge chunk of money every month and free up more room for savings and daily expenses.
However, cash-out refinancing also has some disadvantages:
- You reset the clock on your mortgage – Unless you refinance at a shorter loan term, you will pay off your home longer. Say you had your mortgage for 10 years and you are refinancing with a new 30 year loan. You will borrow (and pay interest) for 40 years. And that will cost you in the long run
- They turn unsecured debt into secured debt – Your car loan is secured on your car. But card debt and personal loans are unsecured. Using a cash out refinance to pay off debt means you are putting your house at risk. And if things go wrong, you could end up facing foreclosure
Some homeowners also get into trouble if they pay off debts with a cash-out refinance and then push their debt back up. This can get you back where you started – but without a cushion of available home equity to protect you.
All of this doesn’t necessarily mean you shouldn’t be doing your cash out refinance. However, these are serious issues that need due consideration.
Before you start, make sure you take the numbers out, set a strict budget, and stick to them once your debts are paid off. A financial advisor can be of great help here.
Cash out refinancing to pay off debt vs. home loans
There are various alternatives to cash-out refinancing to repay debt. And they can help you avoid some of the falls in refinancing.
For example, a home loan would lower your closing costs. That’s because these are based on the amount you’re borrowing. And with a home loan, you don’t refinance your entire mortgage.
Nor would you reset the clock on your main mortgage, which could be a wise choice if your current mortgage is largely repaid.
But you would still be converting your unsecured debt into secured debt. Because home equity loans are second mortgages.
Another alternative could be a personal loan.
These have the advantages of a home loan but also leave your debt unsecured. And they often come with low or no setup fees. However, they usually charge significantly higher interest rates than secured loans. So while you would almost certainly be saving on your credit cards, they wouldn’t be that big.
We are talking about raising large sums of money, often with long-term effects. So, weigh your options carefully and choose a strategy that will benefit you both in the short and long term.
Cash-out refinancing to pay off debt: The bottom line
When you have a lot of high-yield debt that is consuming your monthly budget, using a cashout refinance to pay off that debt can have tremendous financial benefits.
Not only do you reduce your monthly payments, but you can also free up large amounts of cash on regular living expenses, savings, and even investing in your financial future.
Make sure you understand the pros and cons before you start. And, as always, buy the best interest rate on your withdrawal refinancing. The lower your new interest rate, the more you save on all of your debts.
Confirm your new plan (December 7, 2021)