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Are you struggling with high-interest debt? You’re not alone. According to the Federal Reserve Bank of St. Louis, the average household has a credit card balance of $7,226.
But there’s good news if you’re a homeowner. You could use a cash-out refinance to pay off debt.
While a mortgage cash-out refinance can be a great way to use the equity in your home, it won’t be for everyone. Keep reading as we explore what a cash-out refinance is and some things you’ll want to consider before moving forward.
Key Takeaways
- Cash-out refinancing involves taking out a new loan. This loan will include the amount you owe on the home and any equity you want to withdraw.
- Because mortgage rates are significantly lower than credit card interest rates, using your equity can save you significant interest over time.
- If you’re refinancing a conventional or FHA loan, you must keep at least 20% equity in the home. However, if needed, you can pull out all the equity from a VA loan.
What is a cash-out refinance?
When you go through a mortgage refinance, you replace your current mortgage with another. Refinancing is typically done when interest rates have dropped, and you want to lower your monthly payment.
Refinancing will also allow you to change the terms of your mortgage. For example, you may want to switch from a 30-year loan to a 15-year loan to pay off your home faster.
However, when you complete a cash-out refinance, you’re replacing your original mortgage with a new one at a higher balance. The difference is then given to you as a cash payment.
For example, you might own a home valued at $300,000, and your mortgage balance is currently $150,000. If you can tap into 80% of your home equity, you could potentially pull out $120,000 in cash. That means by refinancing, your new mortgage balance would become $270,000.
The cash you pull out of the home can be used for many different things, including:
- Debt consolidation
- Home improvements
- Education expenses
- Emergencies
- Investments
» MORE: See today’s refinance rates
How do I use a cash-out refinance to pay off my debt?
If you decide that using a cash-out refinance to pay off debt makes sense for your situation, here are some tips to get started.
1. Figuring out how much equity you can borrow
Unless you have a VA loan, you won’t be able to access 100% of the equity in your home. That means you’ll need to start by figuring out how much money will be available.
Most lenders will require you to keep at least 20% equity in your home after you complete your cash-out refinance. To understand your maximum cash-out amount, you can use the following equation:
(Home value – mortgage balance) x 0.80 = Maximum cash-out amount
2. Decide how much cash you need
Whether you pay off high-interest debt, pay for a home improvement project, or use the cash for something else, you must decide exactly how much you’ll need. Borrowing more than that means paying additional interest.
3. Shop around for a lender
Shopping around for a lender is critical to the cash-out refinance process. Choose three lenders, including your current lender, and get a rate quote from each.
When you compare these quotes, make sure you look at the interest rate offered and the fees charged. This will allow you to pick the best lender for your situation.
4. Apply for a cash-out refinance loan
Just like you applied for your original mortgage, you’ll need to go through the mortgage application process for your cash-out refinance. This often includes a home appraisal and complete underwriting to examine your finances and credit history.
4. Close on your loan
Once you’ve been approved, you’ll move on to closing your loan. You’ll be responsible for paying closing costs on the loan, but in most instances, this can be rolled into the loan amount.
However, if you choose to go this route, it will reduce the amount of cash you’ll be able to receive.
5. Pay off your debt
Once you’ve closed your loan, the lender will pay off your old mortgage and distribute the cash so you can pay off your high-interest debts.
Will refinancing my mortgage to pay off debt benefit me?
With housing prices up nationwide, using a cash-out refinance to pay off debt, especially credit card debt, can be a great idea for many people. Not only are mortgage rates significantly less than credit card interest rates, but you can also consolidate multiple credit cards into one manageable monthly payment.
Before deciding if a cash-out refinance makes sense for you, consider some of the pros and cons.
Pros
- Mortgage rates are significantly less than the interest rate on credit cards. This can significantly reduce the amount of interest you’re paying.
- If mortgage rates have dropped or your credit score has increased, you might end up with better mortgage terms, which can decrease the interest you’re paying over the life of your new loan.
- Using a cash-out refinance to pay down your credit card balance will reduce your credit utilization. By doing so, you’ll help improve your credit score.
Cons
- Like when you received your first mortgage, you’ll need to pay closing costs when refinancing. If you’re planning to stay in the home for a while, this can make sense. However, it’s important to understand your break-even point, including the interest savings you’ll have from paying off your credit card.
- By doing a cash-out refinance, you’re reducing the equity you have in your home. If you choose to sell, this would reduce the amount of money you have available to use for a new down payment.
- Unless you’re replacing your original mortgage with a shorter-term loan, you’ll end up paying more in interest over the life of your loan. For example, if you have 20 years left on your mortgage and take out a 30-year loan, you’ll reset the clock.
Requirements to consider for debt consolidation
If you’re considering refinancing your mortgage for debt consolidation, you should be aware of a few requirements.
You must have enough equity
Depending on your lender and the loan product, you’ll likely need at least 20% equity in your home before you can do a cash-out refinance. To understand how much equity you have, you’ll need to calculate your loan-to-value ratio (LTV).
This is a percentage of how much you still owe on your home compared to it’s value.
Going back to our previous example, if you own a home with a current mortgage balance of $150,000 and an appraised value of $300,000, your LTV would be 50%. This means you have 50% equity in your home.
Typically, lenders allow you to take out enough equity as long as your LTV stays at or below 80%. Occasionally, you’ll find a lender that lets you go as high as 90%.
Current interest rates
One of the biggest draws of using a cash-out refinance for debt consolidation is that mortgage rates are significantly lower than the interest rates on credit cards. However, before you move forward, you’ll want to consider the interest rate on your current mortgage compared to where interest rates are today.
By crunching the numbers and including the closing costs, you’ll understand if refinancing will be worth it in the long run.
» MORE: Getting ready to buy or refinance a home? We’ll find you a highly rated lender in just a few minutes
Alternatives to the Cash-Out Refinance
If you’re unsure about whether or not a cash-out refinance to pay off debt makes sense for you, consider some of these alternatives:
Ask for a lower interest rate
If you have good credit and you’ve been making all your payments on time, you can ask your credit card issuer to reduce the interest rate on your credit cards. This will help you pay down your balance faster.
This can also be a great option if you’re unsure about paying closing costs and don’t want to reset the clock on your mortgage.
Balance transfer credit cards
If you’re working to pay off credit card debt, you could also use a balance transfer credit card. Many of these cards come with an introductory 0% APR promotion.
The promotional period fluctuates from card to card, typically between 12 and 21 months. During this period, your balance won’t accrue interest, allowing you to pay down your balance faster.
Make sure you can pay off your balance before the promotional period ends, or you’ll start accruing interest. Additionally, most balance transfer credit cards have a 3% or 5% balance transfer fee.
Debt Consolidation Loan
Another option for consolidating debt would be to use a debt consolidation loan. Because these are unsecured loans, you wouldn’t risk losing your home if you default.
The interest rate on a debt consolidation loan will be higher than what you’d receive if you used a cash-out refinance but still lower than most credit card interest rates.
Should I pay off debt with the Cash-Out Refinance?
If you’re dealing with high-interest debt, you might be looking for an option to break free. Using the equity in your home can be a great solution.
However, before moving forward, it’s important to weigh the pros and cons and understand the costs involved.