Consumer debt continues to grow, with the average American holding a balance of $96,371 — a 5.4% increase from 2021 — according to Experian data. This debt is a combination of mortgages, student loans, auto loans and leases, credit cards, retail credit cards, and personal loans.
If you’re a homeowner currently saddled with a large mortgage, you may be thinking about refinancing. A mortgage refinance can help you secure a lower interest rate and, if you’re opting for a cash-out refinance, provide you with funds to pay off other various debt expenses. But is it a good idea? Keep reading to find out when refinancing makes sense.
How refinancing a mortgage works
When you refinance a mortgage, you replace your current mortgage with a new mortgage, and generally a lower interest rate. If your home equity has risen, you can also get cash out of the deal — this is known as a cash-out refinance. The funds you receive from a cash-out refinance can be used toward any expense, including to pay down your debt.
Is refinancing to consolidate debt a good idea?
You may want to refinance your mortgage so that you can free up money to pay for other types of debt.
“If you are drowning in credit card debt and have equity in your home that you can cash out to pay off debt, it can be a good idea,” says Sonja Breeding, CFP and vice president of investment advice at Rebalance.
However, she says that first, you need to make sure refinancing will provide you with enough money to pay off your other debts — not simply extend them.
“And you have to make sure not to keep spending, because this will simply add to your total indebtedness,” Breeding said.
In addition, you’ll need to make sure the new monthly payment is an amount you can comfortably afford.
“The good thing about refinancing is that your new loan should be fixed and predictable — but if it’s still too much to pay every month, refinancing solves nothing,” she added.
How refinancing your mortgage can help you pay off debt
While refinancing your mortgage can be a solution to clear other debt off your plate, keep in mind that mortgage interest rates have been rising over the last year. So, if you already have a relatively low interest rate, refinancing may not be your best option at the moment.
But if you can get a lower rate, there are two ways refinancing can help you pay off those high interest debts.
With a rate-and-term refinance
Best for: Changing the terms of your original mortgage
A rate-and-term refinance is when you refinance to a new rate or a different term (or both). Homeowners who refinance typically do so to lower their mortgage rate, shorten their loan term (which reduces total interest costs), or extend their loan term (which makes monthly payments more affordable). By refinancing to a new rate, you might be able to save $300, for example, and apply it toward other high-interest debt.
With a cash-out refinance
Best for: Tapping into your home equity
As its name implies, a cash-out refinance involves pulling actual money from your mortgage. With a cash-out refinance, you’ll get a new mortgage worth more than your existing mortgage. The new mortgage completely pays off the balance on your existing mortgage, and you receive the difference in cash.
Since there’s more risk involved in these types of loans, you may have to pay a higher interest rate. Still, if you’re attempting to pay down high-interest credit card debt, the mortgage rate you receive on a cash-out refinance will likely be more favorable.
How to qualify for a cash-out refinance
You would qualify for a cash-out refinance in the same way you would qualify for any other type of refinance.
“The lender reviews your credit history, inspects the property and offers you a rate and term, and the length in years of the new mortgage loan,” Breeding said. And if you have been making steady payments and have equity in the home, she says it’s very likely you will qualify for the new loan.
Although qualifications may vary by lender, lenders tend to look at the following:
- Credit history: A score of 680 or higher is typically required for this type of home loan. You may be able to qualify with a lower score if you have more equity in the home.
- Home value: With a cash-out refinance, you can’t take out a new loan for more than 80% of the value of the home.
- Debt-to-income (DTI) ratio: You likely won’t qualify if your DTI ratio is higher than 50%. Aim for a DTI ratio of 36% or less to improve your chance of approval.
- Employment history: Lenders want to see a history of steady employment — usually at least two years — to ensure you have the ability to pay back the loan.
- Savings: Lenders also want to see a few months of cash reserves — generally three to six months — in case you need help covering the mortgage payments.
Pros and cons of refinancing to pay off debt
Refinancing your mortgage to pay off debt can be a tremendous benefit, but it may not be the best solution for your financial situation. These are some of the pros and cons to consider.
- Save on interest payments: If you have high-interest credit cards, refinancing will allow you to save thousands of dollars in interest — money that you can redirect to your savings.
- Get a lower monthly payment: Extending your loan term and lowering your interest rate via a mortgage refinance helps lower your monthly payments as well. With the extra cash flow, you can pay off your debts faster and get out of debt much quicker.
- Stay organized: By combining all of your debt, you don’t have to remember the various due dates since you’re making one payment.
- It takes discipline. Turning unsecured debt, like credit card debt, into secured debt means you’ll have to be diligent about making payments, otherwise you could lose your home.
- You’ll need to pay closing costs. When you refinance your mortgage, you’ll need to pay for the same closing costs that you paid for when you took out your existing mortgage.
- You’ll have less equity. If you cash out, Breeding warns that you’ll have less equity in your home. “You might not have enough equity later to borrow against to remodel the kitchen, for instance.”
Should you refinance your mortgage to consolidate debt?
These are some questions you’ll want to ask yourself if you’re considering a mortgage refinance for debt consolidation:
- How much of a lower interest rate will it be? Ask yourself if the new terms will put you in a better position, especially when considering the costs and fees involved. For example, if the new loan amount only saves you $100 a month, how much is that really worth — and could you have saved that much by simply budgeting better?
- If you do refinance, how do you decide which option to take? It largely will come down to whether you need cash up front to pay for a debt expense, or if the extra monthly savings will be enough to get you by.
- Do you really want to extend the length of your mortgage? You’ll pay thousands of dollars more in interest by doing this. Weigh the benefits and drawbacks and consult with a professional before extending your term.
- Are there other options and different ways to achieve your goals? For example, perhaps you could talk to your creditors about lowering the interest rates on your credit card balances. Or maybe you could take money out of savings to pay off your other bills and debt.