Cash-Out Refinance to Pay Off Debt: Is It Worth It?

By Alvaro Moreira
7 min read

Cashing Out Equity to Pay Off Debt

Can you pay off debt using a cash-out refinance? Most definitely! Actually, a 2021 survey revealed that debt consolidation is the second most widespread reason people seek a cash-out refinance.

Now could be a perfect time to consider a cash-out house equity and settle debts.  Between 2020 and 2021, equity levels increased by almost 30%. What’s more, mortgage rates are at the same time low. Using this technique, eligible homeowners could significantly decrease their debt payments and raise their monthly cash flow.

See How Easy it is to Get Your Custom Rate!
Watch Now ▶
cash-out refinace

Paying Off Debts Using A Cash-Out Refinance

The process involved in a cash-out refinance is the same regardless of whether you’re borrowing to settle debts or for whatever reason. Here are the steps involved:

Determine how much money you require – Don’t take more than you need

Determine the amount you can borrow – Lenders won’t give you all your equity. Many will need you to leave 20% of your equity intact, meaning that your refinance loan will have an optimum loan-to-value ratio of 80%. However, you can refinance 100% of the available equity with VA loans.

See How Easy it is to Get Your Custom Rate!
Watch Now ▶

Apply for your cash-out refinance — This stage is basically the same as when you submitted an application for your initial mortgage. You should expect a review and comprehensive evaluation of your finances, including your credit reports and credit score. You’ll be required to present tax documents, bank statements, and any other proof the lender requires. Below is a documentation list

Proceed to closing — When your mortgage application is authorized, the lender will finish the last steps remaining for closing your loan. Be prepared to read the fine print and also sign 

See How Easy it is to Get Your Custom Rate!
Watch Now ▶

Pay closing costs — The closing costs to refinance are usually 2-5% of the latest loan amount. You can decide to roll over your upfront expenses into the current loan balance if you want. However, they are subtracted from the amount of money you receive at closing

Funds acquired and debts settled — When it comes to a debt consolidation using a cash-out refinance approach, the debts you choose to settle will be settled together with the mortgage that’s being refinanced. Any residual cash after settling both the original mortgage and extra debts will be acquired either through wire transfer or check obtained from escrow

See How Easy it is to Get Your Custom Rate!
Watch Now ▶

When applying, inform the lender that you’re looking to consolidate your debts. That might assist instead of harming your application.  

Additional Stages for a Debt Consolidation Refinance

You might be asked to present the latest statements linking to your debts and stipulate the manner in which they’ll be settled using escrow after closing. Indicate you’ve given this some thought by formulating a summation of your debts, with the amount you’re borrowing roughly matching the sum owed. If there’s a variation, explain why through a cash-out letter of explanation.

The debts you’ve accrued may imply that you’ve had difficulty managing your money. For this reason, also indicate that you’re committed to taking hold of those once your current debts have been paid up.

You can also opt to get assistance from a credit counselor. Or you can come up with a detailed house budget that exposes areas you could save. Though these additional stages take some time, it’s not uncalled for to have to indicate why you won’t return to the same scenario in a few years.

Advantages of Paying Off Debt Using Home Equity

The goal of a cash-out refinance for debt consolidation is to minimize the amount you pay on debts every month. And you do that by moving those high-interest debts to your latest mortgage, which will have a considerably lower interest rate.

Credit cards are the most frequent high-interest debt. And at the time of this read, CreditCards.com totals at an average rate of 16.13%. By distinction, Freddie Mac reported that the average 30-year fixed mortgage rate was 3.11% at the time of this read. 

An Example
Say you have a credit card debt of $40,000. Your average lease payment would be $1,200 or 3% of what’s left. But let’s assume you pay $1,300 per month to remove your debt.

According to the calculations of CreditCards.com, it would take 40 months to clear that debt and would see you incur around $12,000 in interest. 

Now, let’s say you cut down the debt using a cash-out refinance. We’ll imagine you’ve got a 30-year, fixed-rate loan, and the same will be refinanced. And that your current mortgage balance is $200,000 while the value of your house is $400,000.

Lastly, we’ll presume that you’re disbursing a mortgage rate of 4% while your latest mortgage rate will be 3.10%. Now let’s make the computations using a mortgage calculator.  You’re presently paying $955 per month in interest and principal. Upon refinancing, your mortgage balance will be $250,000 (your previous $200,000 + the $40,000 to settle your cards + around, $10,000 in closing costs).

Significant savings

The reduced mortgage rate on your cash-out refinance suggests that you’ll shell out $1,068 every month on your new house loan, just $113 per month more. And you’ll not need to shell out $1,200 per month in minimum card expenditures. 

Overall, that suggests you’re saving about $1,000 each month by covering your credit card debt into your latest mortgage balance.

Considering how their interest rates are elevated, credit card balances are inclined to offer the maximum return when you settle your debts using a cash-out refinance. However, some debts with comparatively high rates can offer worthwhile yet less dramatic savings. So crunch in your figures for personal, auto, and other loans. 

Disadvantages Of Paying Off Debts Using A Cash-Out Refinance 

When you decide to pay off your debt using a cash-out refinance, the first thing to note is that you’re technically not clearing the debt. You haven’t decreased the amount you are indebted. 

Obviously, this approach has significant advantages (as shown above). When you roll over your high-interest debts to a low-interest mortgage, you stand to save yourself a considerable amount of cash every month and make additional room for daily expenses and savings.

However, you should note that there are some fundamental downsides to cash-out refinancing too:

You’re resetting the time on your mortgage — If you decide to refinance to a briefer loan term, you’ll be paying for your house for a long time. Let’s assume that your mortgage runs for a 10-year period and you refinance with another 30-year loan. You’ll be paying interest and borrowing for 40 years. And at the end of the day, it will leave a huge dent in your pocket

You’re converting unsecured debt into secured debt – Your vehicle loan is secured under your vehicle. However, personal loans and card debt are unsecured. Making use of cash-out refinance to settle debt suggests that you’re placing your house at stake.  So if things don’t go well for you, you are likely to face foreclosure. 

Other homeowners also encounter difficulty paying off debts using a cash-out refinance and then ramping up their debts again. This can place you right back where you began – but without a safety net of available house equity to safeguard you. 

Nothing of the aforementioned necessarily suggests that you shouldn’t proceed with your cash-out refinance. However, these are major points that need to be taken into account. 

Before beginning, run the numbers, come up with a strict budget, and adhere to it once your debts are paid up. A financial consultant could be of great help in this case.

Home Equity Loan Vs. Cash-Out Refinance To Settle Debt

There are several options to a cash-out refinance to settle debt. And they can assist you in circumventing some of the pitfalls of refinancing.

For instance, a house equity loan would cut down your closing expenses. This will happen because they are contingent on what you’re borrowing. With a house equity loan, you won’t refinance your whole mortgage.

What’s more, you won’t reset the time on your primary mortgage, which may be a shrewd option if your existing mortgage is significantly paid off. However, you will still be converting unsecured debt into secured debt. This is because house equity loans are second mortgages.

Taking a personal loan is also another option.

These have the benefit of a house equity loan, but your debt will be left unsecured. And they are usually accompanied by zero or low setup fees. However, they usually charge considerably higher interest rates compared to secured loans. Hence, although your credit cards would make some savings, they wouldn’t be that much. Remember that you’re borrowing a large amount of money with long-term repercussions so ensure you weigh your choices.

Cash-Out Refinance to Settle Debt: The Bottom Line

If you’ve got several high-interest debts taking a significant chunk of your monthly budget, making use of a cash-out refinance to settle those debts can have massive financial advantages. 

 Not only will you be in a position to decrease your monthly payments, but you’ll also find that you have a lot of extra cash for regular living costs, savings, and even investing in your future.

Ensure you understand the advantages and disadvantages before you begin. And as per usual, search for the most favorable interest rate on your cash-out refinance. When your interest rate is low, the more you’ll save.