Cash-Out Refinancing To Pay Off Debt: Is It Worth It?
Collect equity to repay debt
Can You Use Cash-Out Refinancing To Pay Off Debt? You bet! In fact, a 2021 survey found that debt consolidation is the second most common reason for refinancing with cash.
This might be a particularly good time to cash in on your home equity and pay off your debt. Capital levels have increased by almost 30% between 2020 and 2021. And mortgage rates are still low.
Qualifying homeowners could significantly reduce their debt payments and increase their monthly cash flow using this method.
Check your eligibility for withdrawal refinance. Start here (December 7, 2021)
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How to use cash-out refinancing to pay off debt
The process of refinancing with withdrawal is the same whether you are borrowing to pay off debt or for any other reason. The stages are:
- Calculate how much money you need – Do not borrow more than necessary
- Calculate how much you can borrow – Lenders will not lend you all of your capital. Most require that you leave 20% of your equity intact, which means your refinance loan will have a maximum loan-to-value ratio of 80%. But those with VA loans can sometimes refinance 100% of their equity.
- Request your withdrawal refinance – It’s pretty much the same as when you applied for your original mortgage. Expect a thorough assessment and investigation of your finances, including your credit score and credit reports. You will need to provide bank statements, tax documents and any other proof required by the lender. here is a documentation checklist
- Proceed to closure – Once your mortgage application has been approved, the lender will take the final steps necessary to close your loan. You will have a bit of reading and signing to do
- Pay closing costs – The closing costs of the refinancing are generally 2 to 5% of the new loan amount. You can usually carry your initial charges over to the new loan balance if you wish. But they will be deducted from the amount of money you get at the close
- Funds received and debts repaid – With a debt consolidation withdrawal refinance, the debts you choose to pay off will be paid off at the same time as the refinanced mortgage. Any funds remaining after paying off both the original mortgage and additional debts will be obtained either by wire transfer or by physical check provided by Escrow.
When you apply, let the lender know that you are going to consolidate your debt. This can help rather than hurt your application.
You may be asked to show current statements of your debts and how they will be repaid through escrow after closing. Show that you’ve thought carefully by preparing a summary of your debts, with the total amounts owed roughly equal to the amount you are borrowing. If there is a difference, explain why using a withdrawal explanation letter.
The debts that you have accumulated may suggest that you have had problems managing your finances. So also show that you are determined to take control of these once your existing debts have been repaid.
You may be willing to get help from a credit counselor. Or you can put together a detailed household budget that reveals areas where you could save money. While these extra steps take time, it’s not unreasonable to have to show why you won’t find yourself in the same situation in a few years.
Check your eligibility for withdrawal refinance. Start here (December 7, 2021)
Benefits of using home equity to pay off debt
The goal of cash-out refinancing for debt consolidation is to reduce your monthly debt payments. And you do this by shifting those high interest debts onto your new mortgage, which should have a much lower interest rate.
The most common high interest debt is the credit card. And CreditCards.com estimates the average rate at the time of writing to be 16.13%.
In contrast, the average 30-year fixed mortgage rate at the time of this writing was 3.11% according to Freddie Mac.
Suppose you owe $ 40,000 in credit card balances. Your typical minimum payment would be $ 1,200 or 3% of the balance. But let’s say you pay off $ 1,300 a month to pay off your debt.
The CreditCards.com calculator says it would take you 40 months to pay off this debt and would cost you around $ 12,000 in interest.
Now, suppose you paid it off using a cash-out refinance. We’ll assume you have a 30-year fixed rate loan and we’ll refinance the same amount. And that your current mortgage balance is $ 200,000 while your house is worth $ 400,000.
Finally, we’ll assume that you are currently paying a mortgage rate of 4% while your new mortgage rate will be 3.10%.
Now let’s run the numbers using a mortgage calculator. You currently pay $ 955 per month in principal and interest. Once you refinance, your mortgage balance will be $ 250,000 (your old balance of $ 200,000 + the $ 40,000 to pay off your cards + say $ 10,000 in closing costs).
The lower mortgage rate on your cash refinance means you’ll be paying $ 1,068 each month on your new home loan, just $ 113 more per month than before. And you will no longer have to pay $ 1,200 per month in minimum card payments.
All in all, that means you’re saving around $ 1,000 per month by incorporating your credit card debt into your new mortgage balance.
Since their interest rates are so high, credit card balances tend to offer the best returns when you use withdrawal refinancing to pay off debt. But other debts with relatively high rates can provide attractive but less spectacular savings. So run your own numbers for auto loans, personal loans, and other loans.
Disadvantages of Using Cash Refinance to Pay Off Debt
The first thing to realize about using cash flow refinancing to pay off debt is that you are not actually “paying off” the debt. You haven’t reduced the total amount you owe. You simply went from one type of loan to another type of low interest loan.
Of course, this strategy has great advantages (as stated above). By pooling your high interest debt into a low interest mortgage balance, you could potentially save a large amount of money each month and create more room for savings and daily expenses.
But cash-out refinancing also has certain drawbacks:
- You reset your mortgage clock – Unless you refinance for a shorter loan term, you will be paying off your home for longer. Suppose you’ve had your mortgage for 10 years and refinance with a new 30-year loan. You will borrow (and pay interest) for 40 years. And, in the long run, it will cost you dearly
- You turn unsecured debt into secured debt – Your car loan is guaranteed on your car. But card debt and personal loans are unsecured. Using cash-out refinancing to pay off debt means you’re putting your home in jeopardy. And, if things go wrong, you could ultimately face foreclosure
Some homeowners also experience problems when they use cash-out refinancing to pay off their debts and then refinance their debts. It can get you back to where you started, but without a net worth cushion available to protect you.
None of this necessarily means that you shouldn’t go ahead with your withdrawal refinance. But these are serious points which require special attention.
Before you start, make sure you calculate well, set a strict budget, and stick to it once your debts are paid off. A financial advisor could be of great help here.
Refinance with withdrawal to repay debt versus home equity loan
There are various alternatives to cash-out refinancing to pay off debt. And they can help you avoid some of the downsides of refinancing.
For example, a home equity loan would lower your closing costs. This is because these are based on the amount you are borrowing. And with a home equity loan, you’re not refinancing your entire mortgage.
You also wouldn’t reset the clock on your primary mortgage, which might be a good choice if your current mortgage is largely paid off.
But you would still turn your unsecured debt into secured debt. Because home equity loans are second mortgages.
Another alternative could be a personal loan.
These have the benefits of a home equity loan, but also leave your debt unsecured. And they often come with little or no setup costs. But they usually charge significantly higher interest rates than secured loans. So while you would almost certainly save on your credit cards, they wouldn’t be as big.
We’re talking about borrowing large sums of money, often with long-term implications. So be sure to weigh your options carefully and choose a strategy that will benefit you in the short and long term.
Cash-out refinancing to repay debt: the basics
If you have a lot of high-interest debt that is eating into your monthly budget, resorting to cash refinancing to pay off those debts can have huge financial benefits.
Not only will you reduce your monthly payments, but you could also free up a lot of money for your living expenses, save and even invest in your financial future.
Make sure you understand the pros and cons before you start. And, as always, look for the best interest rate on your withdrawal refinance. The lower your new interest rate, the more you’ll save on all of your debt.
Check your new rate (December 7, 2021)