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When you're drowning in debt, keeping track of the multitude of monthly payments can be a struggle in itself. Consolidating your debt with cash-out refinancing of your home reduces your regular payments to one: a single mortgage. That’s much simpler.
A cash-out refinance may ease your financial burden, but there’s at least one serious downside to consider: You’re rolling your unsecured credit card debt into your secured home loan. Read on for more information.
What is a cash-out refinance?
Cash-out refinancing involves taking out a larger mortgage and receiving the additional capital as cash. (Hence: cash-out refinancing.) Homeowners with a significant amount of equity in their homes are good candidates for this loan.
Here's how it works. Let's say your home is valued at $400,000. You owe $250,000 on it, which means you have enough equity — $150,000 — to borrow against it (lenders often require you have 10%-20% equity). You can typically borrow 80% of the home value for a cash-out refinance, assuming you qualify. If you want to pay off your current mortgage and take out extra to pay off a $25,000 loan, your new cash-out refinancing mortgage would be $275,000.
Unlike standard refinancing, this method does more than simply change your interest rate or the terms of your loan. "A cash-out refinance takes equity that's illiquid and makes it liquid, in order to do something else," said certified financial planner Justin Goodbread.
First, the new sum is used to pay off your initial mortgage. The remainder is yours to do with as you wish. Many homeowners use this cash to improve their home, finance businesses, pay for large expenses like college — or consolidate their debt.
Using a cash-out refinance to consolidate debt
If you have significant unsecured debt — such as credit card debt — a cash-out refinance may help you save interest or reduce your monthly payment. Mortgages offer some of the lowest interest rates. For example, the 2018 average credit card interest rate for interest-bearing accounts was 15.32%. Current 30-year mortgage refinancing rates are around 4.58%. That's a significant savings.
For example, let's say Raquel owns the $400,000 home we mentioned above. She has $250,000 left on her 30-year, 4.58% mortgage, and $25,000 in a personal loan she uses to pay off medical debt. The interest rate for her personal loan is 12%, with a 10-year repayment term. Here's how refinancing may help Raquel. Every month, she pays $1,841 for the mortgage and $359 for the personal loan, bringing her outlays for both to $2,220.
If she gets a cash-out refi, assuming assume her mortgage interest rate remains the same, here’s how much she could lower her payments.
|Existing mortgage||Cash-out refinance|
|Original loan amount||$360,000||$275,000|
|Mortgage balance before refinancing||$250,000||N/A|
|Personal loan balance||$25,000||N/A|
|Interest rate||4.58% for the mortgage. 12% for the personal loan.||4.58%|
|Monthly principal and interest (30-year mortgage; 10-year loan repayment term)||$1,841 for the mortgage. $359 for the personal loan. Total: $2,200||$1,406|
Cash-out refinancing helps Raquel save $794 every month on loan payments.
Advantages and disadvantages of using a cash-out refinance to consolidate debt
As you saw above, cash-out refinancing can help you save a bundle of cash on a monthly basis — especially if you’re stuck with unavoidable high-interest debt, like a medical loan. "Life happens," said Goodbread. Cash-out refinances "get cash out of the walls of your house, and create more leverage, which can be used to pay off medical bills, student loans, and bad debt."
Here are some advantages of cash-out refinancing for debt consolidation:
- Decrease your monthly payment and juggle fewer payments.
- Pay less in interest, which may allow you to pay off the loan more quickly.
- Take advantage of home equity, which otherwise goes unused.
- Potentially change a variable-rate loan to a fixed-term mortgage, which may make it easier to budget.
But cash-out refinancing isn't a magic bullet — especially if you're refinancing high-interest credit cards. "You're enabling the very behavior that put you there to begin with," said Goodbread. Unless refinancing is part of a broad financial wellness strategy, you may soon find yourself in the same situation.
Only now, your mortgage is larger. If you can’t repay credit card bills, your lender can’t come after your house. But if you can’t repay your mortgage, you could face foreclosure. This is a critical point to keep in mind when considering a cash-out refinance for debt consolidation.
Here are some other cons of cash-out refinancing:
- Your home will take longer to pay off.
- Closing costs can be high, and may need to be financed into the loan.
- Part of the interest isn't tax-deductible if you use it to consolidate credit card debt.
Is a cash-out refinance right for you?
Despite the risks to your property, a cash-out refinance may be right for you if you don’t have other options, such as an unsecured debt consolidation loan or balance transfer credit card. Here are a few things to consider:
Do you have a comprehensive payoff plan? Was the debt incurred because of poor habits or because of an emergency or life change — like medical loans or moving costs? If you don’t have a plan for avoiding the kinds of debts you racked up, you could just be putting your home at risk. In that case, you’d probably be better off getting some credit counseling and entering a debt management plan to pay off what you owe.
How long do you plan to stay in the home? If you plan to move within five or 10 years, that’s another situation in which a cash-out refinance may not the best choice. If you're not putting down long-term roots and need home equity to fund a down payment in a new house, tying up your current home with a cash-out refinance may not be a good choice.
How much equity do you have in the house? Many lenders require homeowners to keep 10% to 20% equity in their home. Be careful about borrowing too close to the maximum. "You should have enough equity in the house that, should you have to fire-sell your house, you're not facing bankruptcy," Goodbread said. Your financial advisor can ensure you're borrowing a smart amount.
Finding a lender
If you think a cash-out refinance for debt consolidation is right for you, Goodbread recommends first checking with your financial advisor or tax accountant, if you have one. "Have them double check the math," he said. They may also be able to provide a personal recommendation for a lender.
You can also look for refinance lenders online, which makes comparing rates and terms easy. But no matter who you choose, Goodbread recommends checking references and reviews. Make sure the lender specializes in cash-out refinancing, too — not every lender offers these services.
But the most important factor is that you're comfortable. "You may want to work with a live person face-to-face," Goodbread said. In that case, consider skipping the virtual lenders for a local option recommended by your advisor, friends or neighbors.
The bottom line
Before diving in, make sure refinancing will actually decrease your payments and interest costs over time, and consider your long-term home ownership and debt management plans. But if you're drowning in unexpected high-interest loans, this may be the fresh start you're seeking. It will turn multiple monthly payments and high interest rates into a smaller, and hopefully more manageable expense.