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If you own a house, you might be able to take out a cash-out refinance for paying off high-interest debt. But you need to be aware that using the equity in your home for consolidating and paying off other debts has both pros and cons.
It is very important to understand your goals as well as your current financial situation to determine whether or not it is the best solution for you to use. If you want to see exactly what your rate and closing cost options will be based on your situation, take 30 seconds and get your custom rate quote.
What is a Cash-Out Refinance?
Your current mortgage loan can be replaced with a new one by using a mortgage refinance loan. Mortgage loans are often refinanced by homeowners to get a lower monthly payment and interest rate. As your home’s value appreciates and the principal amount on your loan continues to go down, a cash-out refinance can be used to access some of the equity in your home that has been built up.
For example, say that the balance on your mortgage is currently $250,000 and your house is valued at $400,00. You will be allowed by many lenders to borrow as much as 80% of the value of your home, so potentially your loan could be refinanced for as much as $320,000.
The amount you will receive in cash is the difference between the amount of the new loan and your original loan balance. That money can be used for almost anything that you want to, including the following:
- Major expenses
- Education savings
- Retirement savings
- Emergency expenses
- Home improvements
- Debt consolidation
However, just because you own a house, doesn’t automatically mean you are eligible to use a cash-out refinance. To begin with, there will need to be enough equity in your house to meet all of the lender’s requirements, including the 80% loan-to-value ratio.
Several other factors will also be considered by lenders including your job security, income, debt-to-income ratio, credit report items, credit score, and more. If you have bad credit, it is still possible to qualify for a cash-out refinance. However, not all lenders work with subprime borrowers. Also, other eligibility requirements may need to be met in order to qualify for this type of loan.
Risks of a Cash-Out Refinance Being Used for Debt
One of the main reasons why a cash-out refinance should be considered for consolidating high-interest debt is that usually you can obtain a much lower interest rate on mortgage loans compared to expensive credit options such as personal loans and credit cards. However, there are also some potential risks that can significantly impact your finances:
Threat to your house: When a cash-out refinance is used for consolidating other debts, basically you are converting secured debt into secured debt. You will have a higher monthly mortgage payment, and if you are unable to make your payments, then you may be at risk of default and foreclosure. By contrast, if you default on a personal loan or credit card, your credit can be harmed but you won’t lose your house.
Closing costs: Fees on a mortgage loan refinance can range from 2% to 6% of the amount of the loan. Usually, you can choose to either have these costs rolled into your new loan or pay them upfront. If they are paid upfront, the savings gained from consolidating your high-interest debt needs to be higher than the amount of the closing costs. When they are rolled into your new loan, it will reduce the amount you can qualify for. You will also have to pay interest on your closing costs for the life of the loan.
Impact your credit score: During your application process, a hard credit inquiry will be run by lenders on your credit reports. The result can be a few points being knocked off of your credit score. In addition, when a new loan is added to your credit report it reduces the average age of your accounts. This can have a negative impact on your credit score as well.
As you are considering your options, it is essential to weigh the pros as well as the cons to determine the best option for you. Be sure to run the numbers to find the best option for your individual situation.
Alternative Methods for Paying Off Debt
If you are unsure whether you should use a cash-out refinance to pay off debt, the following are some alternative options that can be considered:
Debt consolidation loan: A personal loan can be used for consolidating and paying off other high-interest debt. Although the process is very similar to taking out a cash-out refinance loan, typically personal loans are unsecured, so if you default you won’t need to worry about losing your house.
Balance transfer credit card: To pay off credit card debt, it might be possible to apply for a new credit card that has a 0% APR introductory rate and transfer your debt onto the new credit card. Balance transfer credit cards can be very appealing since it makes it possible to get rid of debt interest-free – assuming the transferred debt is paid off before the 0% APR introductory rate comes to an end. Also, be aware that you will usually need to pay a 3% to 5% fee on the amount that is transferred.
Request a lower interest rate: If your credit card accounts have a positive payment history and your credit is good, you can call your credit card companies and request a lower interest rate. It can save on the amount of interest you have to pay you can become debt-free sooner if you are eligible.
Use the ‘avalanche payoff’ or ‘debt snowball’ method: With the debt snowball method, you pay the minimum amounts on all of your debts and then first focus on paying more on the debt that has the smallest balance. After that account has been paid off, apply the amount of the payment as an extra amount on your next-smallest balance and keep using this process until all of your debts have been paid off. Another way that your debt payoff can be accelerated is to use the debt avalanche method. The balance that has the highest interest rate is targeted first. Over time, you will save the most money with this method.
First Get Your Credit Right
Whether you select a balance transfer credit card, debt consolidation loan, cash-out refinance, or another option, it is critical to make sure your credit is good.
Review your credit score to find out where it is, and check for any areas that need to be improved. You might also want to look for more context on your credit report and look for any potentially inaccurate information that may be having a negative impact on your credit score. If you are not happy with where your credit is, take the necessary steps for improving your credit score prior to applying for a new loan. The process may take time, but a lower interest rate can save hundreds or thousands of dollars.
The quickest way to get stated with your mortgage is by checking your rate. It takes less than 30 seconds to see your custom rate and closing cost options.