What is a Debt Consolidation Loan?
Some homeowners may refinance their home so that they can pay off a debt, such as credit card balances. They can do this with a cash-out refinance, or debt consolidation loan, which means they get a mortgage for more than they owe on their home, take the difference in cash and pay off their high-interest debt with it.
Using the cash-out refinance method allows you to make fixed payments over a period of time, rather than paying a revolving balance each month. An advantage to this is that mortgage rates are typically lower than credit card interest rates.
So, you end up owing the same amount but you pay off the high-interest credit cards debt and replace it with a lower-interest loan debt.
Should You Refinance to Pay Off Debt?
Before you decide to refinance in order to pay off any debt, you need to be sure you have enough equity in your home. You will have to buy mortgage insurance if you end up owing more than 80% of your home’s value after you refinance.
To avoid this scenario, you will need to calculate your loan-to-value ratio. You do this by dividing your mortgage balance by the approximate value of your home.
If you are going to cash out some of the equity to pay off some debt, you’ll need to add the amount of debt you’re paying off to the loan amount. If your lone-to-value ratio is less than 80%, you’ll be able to cash out enough equity to pay off your debt without paying for any mortgage insurance.
Another Factor to Consider – Closing Costs
Before you refinance to pay off any debt, you’ll need to consider closing costs. Service providers and lenders charge hundreds or thousands of dollars in fees when you refinance a loan. That is money you could be better used to pay down your debt. You’ll need to compare the closing costs with the overall interest savings on the debt that’s being consolidated. The interest savings should exceed the closing costs.
Is Refinancing a Good Idea to Consolidate Debt?
Before you consider consolidating your debt, you will want to have a plan so that you don’t end up running up debt again.
Credit card debt is unsecured, meaning that it’s not backed by any collateral. So, if you if stop making payments to the credit card company, they can’t take your home. However, is you stop making payments on your mortgage, the lender can take your home. Therefore, if you decide to pay off credit card debt with a consolidation loan, you end up increasing your risk of losing your home.
Remember that when you perform a cash-out mortgage, you’ll be increasing your mortgage balance. Even if you refinance at a lower rate, your monthly payments may still increase. It’s important to look at all of your available options so that you can find the loan the best fits your needs and goals.