Cash-Out Refinance for Debt Consolidation: Is it Worth it?

Are you feeling weighed down by debt? If you are a homeowner, getting a cash-out refinance can be a solution that provides the relief you are looking for.

This type of home loan allows you to borrow more than what you owe on your current mortgage in order to receive a cash surplus at closing. You can then use those funds to pay off your debt and consolidate it into one, simple payment. Read on to discover how it works, plus the risks and benefits of this debt consolidation strategy, so you can decide if it is a good option for you. 

How does a cash-out refinance work?

There are various strategies you can employ for the purpose of consolidating debts. Some people consider taking out credit cards with low initial rates for balance transfers, or they may prefer using a personal loan.

One option is exclusive to homeowners—a cash-out refinance. This type of refinance replaces your current mortgage with a larger home loan in order to receive a cash surplus. The exact amount will depend on the amount of equity you have available in your home. Here is a quick, real-life example of how it works:

Joe’s current mortgage balance is $200,000, and his home is worth $400,000. He has $50,000 of debt on high-interest credit cards and a personal loan. Even though he is making good money, he does not have extra funds. Getting a cash-out to refinance for $250,000 will pay off his current mortgage and give him cash to pay off his high-interest debt. Although his mortgage payment will be higher than his current one, the increase will be slight since he is getting a low interest rate. 

Cash-out refinance limits and requirements

How much cash you can take out depends on the amount of home equity you have available. You do not want your loan-to-value (LTV) to exceed 80%. That is because keeping your LTV at 80% or lower can help you avoid private mortgage insurance (PMI). Other requirements borrowers must meet include:

• Your current home loan meets its seasoning requirements, typically achieved once you have made six consecutive mortgage payments

• You have a minimum of 20% home equity; however, this will vary depending on your chosen lender

• Your credit score is 620 or higher, but this also depends on your lender

• You have a debt-to-income (DTI) ratio no higher than 45%

Another thing to keep in mind when you apply for your mortgage is that the underwriter will look at your DTI ratio. If your debts are too high compared to your income, the underwriter may still approve your loan with the stipulation that you pay off the debt at closing. 

What are the advantages of a cash-out refinance?

A cash-out refinance can be a smart way to tap into your home equity, especially when rates are dropping. Even a single percent can make a big difference in the amount of interest you end up paying on your mortgage. Juggling debt also places a burden on budgeting, so it can be a relief to have only one monthly fixed payment.

Depending on your home equity, you may even end up with additional funds that can be used however you want. This includes:

• Making home improvements or renovations 

• Paying off student loans, high-interest credit, and personal loans

• Buying another property

What are the disadvantages of a cash-out refinance?

There are some things to keep in mind, though, before you jump into the refinancing process. Remember, a cash-out refinance replaces your current mortgage with a larger home loan. This means you may see an increase in your monthly mortgage payments, though it may still be less than what you currently pay on high-interest credit cards or other debt. However, you will also be resetting the clock on your mortgage and increasing the time it will take to pay it off.

You will also have to consider the closing costs and fees at closing, typically ranging from 2% to 6% of the new home loan’s principal. 

Alternative debt consolidation strategies

Aside from a cash-out refinance, there are other ways to tap into your equity for funds. Home equity loans and home equity lines of credit (HELOC) offer homeowners the option of borrowing against their equity without refinancing their mortgage. Here is a quick breakdown:

1. A home equity loan is a type of second mortgage that provides you with a lump sum of funds at closing.

2. A HELOC is a revolving line of credit based on your home equity. Your lender sets a limit, and you can access the funds as you need them during the draw period.

Tapping into your equity is not the only way to consolidate debts. For instance, personal loans can be used to the same effect. However, it should be noted that every solution has its own advantages and disadvantages. And just like a refinance or home equity loan, you will have to account for origination fees and closing costs.  It’s important to note that not all lenders offer home equity loans and lines of credit.

Tips for consolidating debt wisely

If you decide to consolidate your debt by using some of your equity, it is essential to stick to a budget. By budgeting wisely, you may still have money to do the fun things in life that you enjoy, plus save some cash along the way. Additionally, it is a smart idea to take some of your new savings and pay extra on the principal of your mortgage each month. That will help pay your home loan down faster.

The first step to conquering your debt is understanding your options. As a homeowner, it can be a relief to know that your home is also an asset. Be sure to consult with an experienced lender who can walk you through all of ins and outs of a cash-out refinance.