Should You Cash-Out Refinance to Pay Off Debt?

With a cash-out refinance, besides refinancing your current mortgage, lowering the rate, and possibly changing the term, you can also convert some of your home’s equity to cash. Gaining access to extra funds at a low interest rate could be a good option if you use those funds wisely. In fact, you can even consolidate debt by refinancing your mortgage. A home mortgage debt consolidation can help pay off credit cards and debts. Let us take a look at the thinking behind using a cash-out refinance to pay down high-interest debt and help you determine if it makes sense for you.

What is cash-out refinancing?

Like any other type of refinancing, a cash-out refinance involves replacing your current home loan with a new one, ideally with a lower rate. But unlike a typical refinance, you will also receive a lump sum of cash that will be rolled into the repayment of the rest of your mortgage. Homeowners can use these funds in a variety of ways:

• Home improvement. The advantage of using your funds for home improvement is that you are reinvesting your money. And if you choose projects wisely, you may be able to increase the value of your home.
• Investing in another property. Using your equity to purchase another property or as a down payment can be a smart move—if you do it properly and avoid the pitfalls. If you are gaining equity or have an immediate renter, that reduces your risk.

• Paying off student loans. If refinancing student loans is not an option, paying them off with a cash-out refinance might be. But be aware of the risks associated with converting unsecured student loans and securing them with your home.

• Paying off personal loans. Many banks and credit unions offer personal loans. Sometimes they may be called home improvement or debt consolidation loans. These are unsecured. If you pay them off with your cash-out refinance, you will be securing them with your home. Make sure you weigh the pros and cons.

• Paying off Credit Card Debt. Tackling high-interest credit cards can give you much-needed financial relief. We will discuss this in more detail later in this article.

How does a cash-out refinance work?

With this type of home loan, you can borrow more than your current mortgage, receive the excess money at closing, and use those funds to pay off debt. The process is essentially the same as any refinance. The main difference is the cash you will receive.

Here is an example of how a debt consolidation mortgage refinance works: 

Joe’s current mortgage balance is $200,000 and his home is worth $400,000. He has $50,000 worth of debt. These are high-interest credit cards and a personal loan that is putting a burden on his budget. Even though he is making good money, he does not have very much spending cash on hand. Plus, he is stressed out because so much of his money is going toward high interest. 

Using a cash-out refinance to get $250,000 can pay off his current mortgage and give him money to pay off his debt. Although his new mortgage payment will be higher than his current one, the increase will be slight since he is getting a lower interest rate. Joe decides to apply for a cash-out refinance to get some relief. 

Keep in mind, the amount of cash you can take out depends on the amount of equity you have available. You do not want your loan-to-value ratio (LTV) to exceed 80%. That is because by keeping your LTV at 80% or lower, you can avoid private mortgage insurance (PMI). 

Debt consolidation versus mortgage refinancing 

There are debt consolidation loans that have nothing to do with a mortgage. Sometimes they are called personal loans. With that type of loan, you can pay off debts and have one monthly payment instead of paying multiple lenders. The principal stays the same, but with your new loan, the payment terms change.

Now, let us compare that to a cash-out refinance. Although your mortgage balance will increase because of the extra money you are taking out, if your rate is lower, you may end up saving on interest—especially compared to your old credit cards. But whether a personal loan or cash-out refinance makes sense to you will come down to a wide array of specific variables.

What are the pros and cons of using a cash-out refinance to pay off debt?

What are the advantages of a cash-out refi? If you can lower your interest rate by a point or more and use your equity to your benefit—this type of home loan might be right for you. You could have extra money each month when you use part of your equity and pay the debt off. Some other advantages include:

• It is easier to keep track of. When everything is tied to one mortgage payment, there is much less of a chance you will forget to make payments.

• You can work with trusted lenders. If you are happy with your mortgage provider's service, you may want to extend that relationship to help you pay down debt as well.

• You can save with competitive rates. Often you will find the interest rate on a mortgage is lower than that of a personal loan. Of course, the only way to know for certain is by doing your research.

Keep in mind there are some drawbacks to this type of financial tool as well. Some examples:

• Your loan is secured to your home. Most personal loans are unsecured. If you fail to repay a personal loan, you will face consequences, but you will not lose your house.

• It may take longer to pay off. Because most mortgages are repaid over longer terms, your cash-out equity will also take longer to pay back. 

• Smaller payments on debt can be beneficial in the short term. But by stretching the repayment schedule, there is a chance you will still be paying a lot in interest.

Your decision to consolidate debt with a personal loan, cash-out refinance, HELOC, or other method will come down to your personal situation—your goals, risk-tolerance, income, expenses, and more. But if you do use a cash-out refinance, just remember to stick to a budget. And, you can always decide to pay extra into your principal each month and speed up the repayment to save over time.

Is it a good idea to refinance to pay off debt?

Cash-out refinance rates are higher than if you do not get cash out. Sometimes it is worth it. Other times it is not. That is where it helps to use a mortgage calculator and consult an amortization schedule. Mortgage rates can also vary between financial institutions, so compare a few different mortgage lenders. No one wants to pay a higher interest rate if they do not have to.

See how much your monthly mortgage, credit cards, and loan payments are now and compare them to a new mortgage that consolidates the debt into your mortgage. Find out how much interest you would be paying if you refinance and compare that with what you are paying now. Doing this will help you decide if refinancing is a good option. As always, it can be helpful to talk to an expert for help and guidance with any financial decision.