Mortgage Refinance to Pay Off Debt
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Some homeowners refinance to pay off debt, such as credit card balances. There are multiple benefits to this approach — for starters, it combines your debts into a single loan, which may make them easier to manage. Refinancing allows you to pay off high-interest debt, replacing the balance with a lower-interest mortgage. Additionally, you can give yourself a longer repayment timeline, since you’re restarting the clock on your debt.
You have several options for using your mortgage to consolidate and pay off debt, and the best path for you depends on your goals and circumstances.
Cash-out refinances: for borrowers with equity who can lower their rate
A cash-out refinance replaces your current mortgage with a new, larger loan, with the ability to use your equity — the difference between the value of the home and what you owe — to pay off your debt.
In order to qualify for a cash-out refinance, you’ll typically need to retain at least 20% equity in your home. For example, if your home is worth $400,000 and you have a remaining mortgage balance of $200,000, you may be able to access $120,000 of your equity (80% of your $200,000 stake in your home) to pay off your other debts.
Because your cash-out refinance loan is fixed to an asset — your home — the interest rate is likely to be lower than unsecured debt like personal loans or credit cards.
This can be a good option if today’s interest rates are lower than your current mortgage rate. If your rate will go up by refinancing, you’ll want to be sure that the interest savings from consolidating your other debts are enough to offset the higher mortgage costs.
Rate-and-term refinance: for borrowers who want to lower monthly payments
If current mortgage rates are lower than yours, another option is to do a straightforward rate-and-term refinance. This will replace your loan with one of the same size, but with a different interest rate and new repayment terms. In addition to having a lower rate, refinancing gives you the option to extend your timeline. For example, if you have 20 years remaining on your mortgage, you could refinance to 30 years and stretch your payments for an extra decade.
This could free up additional cash each month that could go toward paying down your outstanding debts, without sacrificing any equity in your home.
How closing costs figure into your decision
Closing costs are another factor to consider before you refinance to pay off debt. Lenders and service providers charge hundreds or thousands of dollars in fees when you refinance a mortgage. That's money you could otherwise use to pay down debt.
Compare the closing costs with your overall interest savings on the consolidated debt; you want the interest savings to exceed the closing costs.
In other words, it may make sense to spend $3,000 on mortgage closing costs to save $12,000 in interest, but not to save $2,000 in interest.
» MORE: Closing costs calculator
HELOCs and home equity loans: for borrowers who want to keep their mortgage rate
If current mortgage rates are higher than yours, it may not be ideal to refinance. Instead, you could extract your equity by getting a second mortgage.
One option is to get a home equity loan, which you receive as a lump sum that you pay back at a fixed interest rate (typically over 30 years). Your primary mortgage rate stays the same, and you can usually borrow between 80%-85% of your equity.
Alternatively, you can get a home equity line of credit (HELOC). You can borrow from the line up to a certain limit, usually 80%-85% of your equity. The interest rate is generally variable, so each draw will have a different interest rate that moves up and down with the market. Most lenders allow you to draw from the line for 10 years, followed by a 20-year repayment period. Like a home equity loan, a HELOC allows you to retain your primary mortgage rate.
Both HELOCs and home equity loans are secured by your home, meaning that you are likely to get better interest rate offers than you would with other types of loans or credit cards. However, one drawback is that you risk losing your home to foreclosure if you cannot keep up with payments. If debt is a persistent struggle, you’ll want to be careful about mortgaging your home to pay for it.
Pros and cons of refinancing to consolidate debt
Consider the following benefits and drawbacks when deciding whether refinancing is your best option for managing your debts.
Mortgages typically have lower interest rates compared with other types of loans, making them an appealing tool to eliminate high-interest debt.
Lowering your interest rate and/or extending your loan term can free up cash each month, which can go toward your debt payments.
You have multiple options for using a mortgage to refinance your debt, including home equity products that allow you to maintain your existing mortgage rate.
You’re combining your debts into a single loan, which may be easier to manage.
You’re using your home as collateral for your debt, which puts you at a higher risk of foreclosure if you can’t keep up with payments.
If you extend your mortgage term when refinancing, you may pay more in interest over the life of the loan.
It may not address the root cause of debt problems — it’s possible that you will also have to make lifestyle changes in order to avoid additional debt.
You will have to pay closing costs when you refinance, which should be factored against potential interest rate savings.
