Is debt holding you back from achieving your financial goals? You’re not alone. Many Americans struggle with saving for the future while meeting their current obligations. There are a few options out there to rein in debt, but some are more ideal than others.
Can you take money out of your house to pay off debt? This is one option, and it may be timely. Equity levels rose by nearly 30% between 2020 and 2021. And mortgage rates are still relatively low, which means borrowing money may be cheaper.
As a homeowner, you could substantially lower debt payments and increase monthly cash flow at the same time by using this method.
How a cash-out refinance works
The process for a cash-out refinance is not much different than when you’re working to pay off any kind of debt. The steps are as follows:
Determine how much cash you need – Don’t borrow more than necessary.
Negotiate how much you can borrow – Lenders won’t lend you all of your equity. Most require that you leave 20% or more. In effect, this means your refinance loan will have a maximum loan–to–value ratio of 80%.
Apply for your cash-out refinance – You can expect a similar process to when you applied for your original mortgage. Plan for an appraisal and a thorough vetting of your finances, including your credit score and credit reports. You’ll need to furnish bank statements, tax documents, and any other supporting documents the lender might require.
Proceed to closing – Once your mortgage application gets the green light, the lender will proceed with the closing. Expect to sign more paperwork.
Pay closing costs – Refinance closing costs are typically 2–5% of the new loan amount.
It might be helpful to know that you can usually roll your upfront costs into the new loan balance if you wish. But that will be factored in and deducted from the amount of cash you get at closing. When debt consolidation is the objective, the debts you opt to pay off will be paid off along with the mortgage being refinanced. Any outstanding funds after paying off both the initial mortgage and additional debts will be delivered to you either via wire transfer or physical check provided from escrow. When you submit your application, it’s recommended that you let the lender know you’ll be consolidating your debts. This may be a boon to your situation.
Navigating the debt consolidation refinance process
As mentioned above, this process is not unlike that of mortgage origination. For instance, you may be asked to provide current statements relating to your debts and provide a plan for how they’ll be paid off through escrow after closing. You can do your due diligence by preparing a summary of your debts, with the total sums owed roughly matching the amount you’re borrowing. If there’s a discrepancy, explain the situation using a cash-out letter of explanation.
The debts you’ve acquired may suggest that you have had problems with money management. So, it’s important to make the case that you’re resolved to take control of those once your existing debts have been cleared. For instance, you might agree to meet with a credit counselor or come up with a detailed budget that takes into account how you can tackle the debt at hand.
Pros and cons of paying off debt with a cash-out refinance
The purpose of a cash-out refinance for debt consolidation is to help you reduce your monthly payments on debts. To that end, you transfer those high–interest debts to your new mortgage, which should have a much lower interest rate.
However, that doesn’t mean there aren’t some downsides to this move. For one, when you use a cash-out refinance to pay off debt, you’re not really “paying off” the debt. It goes back to basic financial literacy concepts — you haven’t reduced the total amount you owe. You’ve simply changed from one type of loan to another, lower–interest type of loan.
Still, that doesn’t mean there aren’t significant benefits to this strategy. By consolidating your high–interest debts into a low–interest mortgage balance, you could potentially reduce your monthly financial liability and free up more room for savings and other obligations.
Revisiting the potential negative points of cash-out refinancing, you should know that you're resetting the clock on your mortgage. Unless you refinance to a shorter loan term, you’ll be paying off your home for longer. Suppose you’ve had your mortgage for 10 years and refinance with a new 30–year loan. In the end, you’ll be borrowing (and paying interest) for 40 years.
Another consideration: you're converting unsecured debt into secured debt. Your car loan is secured on your car. But card debt and personal loans are unsecured. Using a cash-out refinance to pay off debt means your home becomes leverage. And, if things go south, foreclosure could be the scary outcome.
Some borrowers may get in hot water again if they use a cash-out refinance to pay off debt and then run their debts back up again. This can mean you’re back where you started – but without a cushion of available home equity as a safeguard.
As with any financial move, it’s critical that you understand what you’re signing for ahead of time. In the case of a cash-out refinance, make sure you run the numbers, and set and follow a strict budget. A financial advisor could be a big help here.
Cash-out refinance to pay off debt vs. home equity loan
If getting debt under control is the goal, there are other means to that end that may suit your situation better. For example, a home equity loan would reduce your closing costs. That’s because those are based on the amount you’re borrowing. And in the case of a home equity loan, you’re not refinancing your entire mortgage.
You also wouldn’t be starting over on a primary mortgage, which might be a smart choice if you’ve made considerable progress paying down your current mortgage. However, you would still be turning your unsecured debt into secured debt. (Home equity loans are second mortgages.)
Another alternative might be a personal loan. These offer the same advantages as a home equity loan but also result in your debt being unsecured. While they come with low or zero setup fees, they typically charge significantly higher interest rates than secured loans. So, while you’d benefit from savings on your credit cards, they wouldn’t be as substantial.
It’s important to acknowledge that when borrowing big sums of money, there are often long–term implications. Do your homework and choose a strategy that will benefit you in both the short– and long–term.
The bottom line
If you have a lot of high–interest debt weighing you down, using a cash-out refinance to pay those debts down may offer a lifeline. Not only will you reduce your monthly payments, but you could also free up some cash to help you feel less constrained
Make sure you understand the nuances of a cash-out refinance. Only you can determine if this path is the right option for you and your unique situation. But if you do opt for a cash-out refinance, make sure that you’re equipped to handle all the terms.