Things to Consider When Using a Mortgage Refinance to Pay Off Debt

By Alvaro Moreira
8 min read

Things to Consider When Using a Mortgage Refinance to Pay Off Debt

Are you feeling bogged down with debt? Well, you are not alone. According to recent reports, tens of millions of Americans are currently dealing with hefty credit card debt. And this is in addition to mortgages, medical bills, car loans, and student loans.

Credit card debt is arguably one of the worst kinds of debt to carry. To begin with, it has some of the highest interest rates of any debt, can take years to repay, and doesn’t offer any assets of ongoing value. 

Credit card interest rates tend to be two or three times higher than the rates on most car loans, home loans, and student loans. Fortunately for homeowners, there is a way you can better manage your finances. This is by refinancing your mortgage to repay debt. 

refinance

Can I Refinance a Mortgage to Pay Off Debt?

A cash-out refinance is a type of mortgage refinance that allows you to consolidate your debt by taking advantage of the equity you’ve built on the home over the years as well as low mortgage rates. Given that the interest rates for mortgages are usually lower than for other loans or lines of credit, utilizing a cash-out refinance to pay off debt can save you a lot of money.  

Let’s say, for instance, you take  $16,000 out of your home equity to immediately pay off your credit card debt, that $16,000 will be added to your mortgage. The average credit card interest rate ranges between 15.56% and 22.8%. Now, compare that with the average interest rate on a 15-year fixed mortgage which lies around the 3% mark – the savings earned are enormous. 

With a credit card with that amount of debt, the minimum payment would be $320 as per the calculator of a major credit card issuer. Going with the above interest rate for credit cards, you will be paying $9,496 in interest at the low end or as high as $32,294 in interest at the high end. 

This isn’t realistically achievable since there are minimum loan amounts and you’ll be increasing your balance by the amount of your credit card debt and refinancing your current mortgage. However, this is about making savings on debt interests. 

For added perspective, here’s an example. Assuming that the current interest rate for a 15-year fixed was 3.25% if you consider only the $16,000 in credit card debt, your monthly payments would be $112.43. But if you make at least one of the minimum credit card payment, in the end, you would pay only a total of $1,217.95 in interest and you would clear the entire balance in just over 4 years. Compared to potentially paying almost $33,000 in interest, adding your credit card balance onto your mortgage sounds like a smart financial move. 

Mortgage Refinance Options

Before thinking about refinancing your mortgage, you need to understand the type of options available. First of all, it is important to note that only a cash-out refinance allows you to consolidate your debt. Other options may only help you save money to pay down debt. 

Cash-out Refinance

A cash-out refinance is the only refinancing option that allows you to consolidate your debt. This kind of refinance involves borrowing cash from the equity you’ve built on the home and using it to pay off your other debts such as credit card debt, auto loans, student loans, and medical bills. 

Basically, you merge all your debts into one single debt by transferring them to your mortgage. This way, you only have to make one monthly payment and at a much lower interest rate. 

Rate-and-Term Refinance

With this type of refinance option, a new loan is opened paying off the balance of your original loan. This newly opened loan comes with new loan terms or with a new interest rate. This means that all your future payments will be made to the new loan. 

This option allows you to secure a lower interest rate, which helps you to save money. You can then use the extra money saved to pay off your higher interest rates. 

Streamline Refinance

If you have a government-insured loan and it meets certain criteria, you may be eligible for a VA or FHA streamline refinance. Under this option, no new appraisal is needed. This helps to keep the closing costs down, which makes it an affordable option for managing debt if you qualify. Please note that VA and FHA streamline refinance options don’t allow you to consolidate debt into the loan. Rather, you get access to more of your monthly pay, helping you to reduce your current debts. You also need to have an existing VA or FHA loan. 

Should I Refinance My Mortgage to Consolidate Debt?

Same as with other important financial decisions, it is crucial that you do your research and carefully weigh your options. To help you determine whether a cash-out refinance option is right for you, we have provided a list of questions you should ask yourself:

Do I Qualify for a Mortgage Refinance?

You need to meet the following criteria;

  • A minimum credit score of 620 (580 for VA loans)
  • A maximum debt-to-income (DTI) ratio of 50%
  • Proof of income
  • Money to cover the closing costs

Do I Have Enough Equity?

Given that refinancing requires using the equity in your home, you need to ensure that you have enough to borrow while retaining some in the home. This will be a requirement for most lenders. 

The amount of equity you leave in your home after refinancing affects your loan-to-value (LTV) ratio. Your LTV ratio determines whether private mortgage insurance (PMI) will be applied. Keep in mind that PMI can add hundreds to your monthly mortgage payments. Most lenders will require you to pay this insurance when your LTV is higher than 80%. 

Due to recent changes, it has become more difficult for people with an LTV higher than 80% even qualify. Mostly, only borrowers using a VA cash-out refinance can take cash out with an LTV higher than 80%. This is due to the fact that VA loans allow eligible borrowers to utilize the equity in their homes even if it is below 20%. As far as VA loans are concerned, borrowers are allowed to cash out all of their existing equity if their existing equity is 680 or higher, For other types of loans, you need an LTV no higher than 90%. 

We have provided some formulas below to help you see how cash-out refinance can affect your LTV. 

To determine your LTV, divide your loan balance by the appraised value of your property.

Here’s the formula: 

Loan Balance / Appraised Property Value = LTV

Assuming that the market price of your property is $200,000 and you have a loan balance of $140,000. Your LTV will be 70%. 

Loan balance = $140,000

Property value = $200,000

$140,000 / $200,000 = 0.70

When determining how much your LTV will be with a cash-out refinance, you just need to add the amount of equity you want to borrow to your current loan balance, then divide the total with the appraised value of your property. Here’s the formula:

(Equity Borrowed + Current Loan Balance) / Appraised Property Value = LTV

In the case of the example above, we’ll add on that $16,000 you would take out to pay your credit card debt. The resulting loan balance will be $156,000 and your new loan-to-value ratio after a cash-out refinance will be 78%. 

Loan balance = $140,000 

Property value = $200,000

Cash-out borrowed amount = $16,000

New loan amount = $156,000

$156,000 / $200,000 = 0.78

If you have enough equity left over, you can do a cash-out refinance with a 78% LTV.

Use the above formula to figure out what your LTV will be after a refinance. In case it is higher than 80%, you should consider whether utilizing that equity will give you enough money to accomplish your goals. 

Can I Afford a Higher Monthly Mortgage Payment?

Don’t forget that refinancing doesn’t eliminate your debt, it only transfers it over to another debt – your mortgage.  This means that when you refinance, your mortgage balance increases by the amount of equity borrowed. Thus, if you took out $16,000 from your equity to pay off your credit card debt, the balance on your mortgage will increase by $16,000.

Regardless of the amount of debt you transfer, any increase in your mortgage balance will increase your monthly mortgage payment. 

This increment can be in the amount of a few dollars to a few hundred dollars depending on the terms of your refinance. 

It will be crucial to factor this in when determining your budget and financial goals. If you are struggling to make your monthly payments now, a refinance may not be a good idea for you. Even worse, it can put you at risk of foreclosure. 

Is Mortgage Refinancing Better Than Other Options in Terms of Costs?

When refinancing a mortgage, you’ll need to pay closing costs just like with your original mortgage. Some of the common closing costs include underwriting and origination fees. However, they are others that you’ll need to pay for. These include an appraisal fee, application fee, and an attorney review fee. The total amount of closing costs you will need to pay will depend on the lender you choose, the amount borrowed, and where you reside. 

If you feel that the mortgage refinance option is too high, you can consider using a personal loan to consolidate your debts. The personal loan option is ideal if you:

  • Are looking to keep your equity or haven’t built up sufficient equity to refinance.
  • Want to avoid higher closing costs
  • Want to take out a smaller loan amount

While the closing costs may be substantially lower, you’ll need to be comfortable with paying a higher interest rate than you would with a mortgage refinance. But it will not be as high as those of credit cards. Also, you won’t have the option to deduct interest paid on the said personal loan. 

The Take-Away: Before refinancing to pay off your debt, clearly understand your individual needs and financial goals. The best way to see exactly what you can afford is to get your custom rate and closing cost quote. It’s FREE and takes less than 30 seconds!