Debt Consolidation Mortgage: Should You Get One?

You can consider a debt consolidation mortgage if you need to pay off your maxed-out credit cards, a large debt amount, or high-payment car loans compared to your earnings. Before you decide to do this, make sure you know about the pros and cons of taking out a larger mortgage to settle a debt.

  1. What is a debt consolidation mortgage?
  2. How does it work?
  3. What are the types of debt consolidation mortgages? 
  4. The pros and cons
  5. Alternatives you can consider

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debt consolidation mortgage

Debt Consolidation Mortgage: What is it?

This is where you borrow more than owed on your current mortgage and then use the difference to pay off a loan like student loans, credit cards, car loans, or other debt. There are programs that let you borrow more than the value of your home.

How Does a Debt Consolidation Mortgage Work?

It works like a cash-out refinance, and this is why it is sometimes referred to as a debt consolidation refinance. You are going to borrow more than what you owe now but the cash is going to be used for paying off debt instead of your pocket. The debt accounts are settled through the closing in most instances.

The lender is going to look at your finances to determine whether you can manage higher mortgage payments. You have to do a home appraisal to show that you have enough equity – most loans will allow you to borrow up to 80% of the home value.

E.g. how much you are going to save when you have $300,000 mortgage to pay $50,000 car loan and credit card. The loan has a $250,000 mortgage for $500,000. This example is going to take the monthly payment to $750, and currently, the interest and principal mortgage payment are $1,350 a month.

You are going to save $616 a month when you choose a debt consolidation mortgage. There are some important things you need to think about including changes to your income in the future.

You have financed $50,000 in home equity. If you choose to sell your property, then you are going to end up with $50,000 in profits. When you have paid off your credit card debt, you can start using it. Most lenders will not close your account when the debt is paid using a debt consolidation mortgage, which makes you likely to start using the card.

You will end up paying more in non-tax-deductible interest until the loan is paid off. When you take a large loan amount, it means that you are going to pay more mortgage interest charges. Another drawback: according to the current tax laws, you can’t deduct mortgage interest on the portion of the loan used when paying off the other debt. 

What are the Types?

If your credit score is more than 620 and you have a good employment history, it is possible to borrow up to 80% of the home value when you want a conventional cash-out refinance. The lender is going to verify your income and is going to ask for a home appraisal to determine the actual value of the property. You are not allowed to take a loan of more than 80% of the value, you don’t have to worry about monthly mortgage insurance.

FHA cash-out refinance

Those who have a low credit score like 500 can qualify when it is backed by FHA. Just like the normal cash-out refinance, the cap is 80% of the property value. You will also need to do a home appraisal and proof of income. The drawback of this is that you will pay an FHA mortgage insurance premium. This is usually 0.45% and 1.05% which is then divided by 12 to calculate the monthly mortgage payment. It is a good idea to factor in such costs when determining the cost of the loan.

VA cash-out refinance

Military borrowers who are eligible can borrow up to 90% of the value of their home and the loan is guaranteed by VA. You will need to do a home appraisal and the lender is going to verify your income. This doesn’t have a mortgage insurance requirement; VA borrowers can be asked to pay for VA funding fee which is 2.3%-3.6% of your loan. This is going to depend on if they used the eligibility before.

Home equity loans

Home equity loans will let you take a second mortgage for a given amount before being able to borrow even if you haven’t paid back the current loan. The funds are going to come as a lump sum and the loan has a term and fixed-rate payment. The term of the loan can range between 5 and 15 years.

Lines of credit

HELOCs (Home equity lines of credit) are at first like credit cards, that let you borrow money and then pay it back within a drawback period, which is a set timeframe. The payments are interest-only during this period but they have to be rapid as installments when the draw period ends.

Reverse mortgages

If you have a lot of equity in your home and are over 62 years (if you have 50% or more in equity), then you can consider HECM (Home equity conversion mortgage). This is also known as a reverse mortgage. Unlike the normal mortgages, you are not going to make any payments to the lender, you are the one getting the cash. This money can come as a credit line or lump sum. Your loan balance will be going up instead of coming down every month, which is why you are going to lose the equity in your home with time.

Pros and Cons of Debt Consolidation Mortgage

Below are the pros and cons of debt consolidation mortgages which are going to help you decide if it is the right thing for you or not.

Pros of Debt Consolidation

  • You can use it to pay off high-interest rate credit cards
  • It can help in improving your credit score because you have less revolving debt
  • You will have a little more room in your budget which is going to help you avoid using credit accounts in the future
  • The savings you make can be used for paying down the principal which will let you pay faster
  • You are going to be left with more money that you can use in building up your emergency fund

Cons of Debt Consolidation

  • You are going to pay more in mortgage interests for the life of that loan
  • It is not possible to deduct mortgage interest from the debt payoff
  • If your monthly payments are too high and cannot manage to pay, you risk losing the home to foreclosure
  • You are going to spend about 2-6% of the loan amount as closing costs
  • You are going to end up paying a higher interest rate for your loan

Alternatives to a Debt Consolidation

There are other alternatives you should consider if you aren’t interested.

Personal loans

With a personal loan, you can take a smaller amount but you are going to pay a little higher interest rates compared to debt consolidation mortgages. A personal loan is not secured using your home, which means you don’t have to worry about losing your home if you fail to make the payments. 

Debt management plans

There are credit counseling organizations out there helping people with debt management plans so you can consolidate unsecured debt. You might have to pay for initial setup fees, and it can take a little longer for you to be approved because creditors have to be contacted so they can negotiate terms that they are going to accept. This is a good option for those who cannot qualify for a debt consolidation mortgage because they have collections on their credit report or a low score.