Debt consolidation refinance: How it works, pros and cons

Erik J. Martin
The Mortgage Reports contributor

Is refinancing your mortgage to consolidate debt a good idea?

If you have lots of high-interest debt to pay each month, the costs can quickly become overwhelming. For some, the best road out of this situation is debt consolidation. 

Debt consolidation involves paying off all your high-interest debt with one, lower-interest loan to save on interest payments.

At today’s low mortgage rates, a debt consolidation refinance or home equity loan can be a great way to save money.

But it’s important to understand what’s involved with these strategies — the benefits as well as the potential pitfalls. Securing high-interest debt against your home can be risky, so weigh all the pros and cons before deciding.  

Check your refinance options (Mar 2nd, 2021)

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How debt consolidation works

Debt consolidation is meant to make paying off your debts more affordable on a month-to-month basis. But just how does it work? 

John Sweeney, head of wealth and asset management at Figure, explains: “The goal is to pay off higher-interest debt with a lower-interest source of borrowing. And it’s generally good advice to pay as little interest as possible on the debt you hold.”

High-interest debt typically comes from unsecured borrowing sources, like credit cards and personal loans. “Unsecured” means the lender has no collateral to recoup losses if you default on the debt. (Unlike a mortgage, which is “secured” by your home.)

It’s easy to get in over your head with multiple high-interest payments going to various lenders each month. 

Consolidating your debt by rolling your outstanding balances into a lower-interest mortgage can simplify matters and save you a lot of money.

“Debt consolidation is worth pursuing if you have steady and predictable income and want to make your monthly payments more affordable,” says Michael Bovee, debt expert, and co-founder of Resolve

What is a debt consolidation refinance?

The goal of any debt consolidation strategy is to lower your monthly costs. And, Sweeney points out, the lowest-cost source of money for most homeowners is their primary mortgage.

At today’s low mortgage rates, you could potentially pay off credit card debts with an annual percentage rate of 18-25% using a mortgage loan carrying sub-4% interest. 

So, how does it work?

Homeowners wanting to consolidate debt often use a cash-out refinance. This involves taking out a new home loan worth more than your current mortgage balance. The ‘extra’ loan amount is cashed-out at closing.

You use the cashed-out funds to pay off existing high-interest debt, leaving you with one remaining debt to pay off: your mortgage. In this way, you’re effectively paying off expensive, unsecured debts via a lower-interest mortgage loan.

Funds from a cash-out refinance can also be used to pay off other major obligations, like student loans or medical bills.

But if your goal is to become debt-free faster, then the highest-interest debts should take priority. The money you save can later be applied toward paying down the principal on lower-interest debt like student loans.

And there’s an added benefit. Today’s mortgage interest rates are near historic lows. So there’s a good chance you can lower your current mortgage rate and save on home loan interest as well as the interest on your other debts.

Keep in mind that refinancing comes with closing costs, just like your original mortgage did. These often total 2-5% of the new loan amount — so look for an interest rate low enough that you’ll be able to recoup the up-front cost while saving on your external interest payments.

Check your cash-out refinance rates (Mar 2nd, 2021)

Debt consolidation refinance requirements

If you want to consolidate debt using a mortgage refinance, you have to qualify for the new loan. Requirements vary depending on your current loan type and the type of cash-out refinance you apply for.

First, you need enough equity to pay off the existing debts.

You’ll typically need significantly more than 20% equity to qualify for a debt consolidation mortgage. That’s because most lenders want you to leave at least 20% of your home equity untouched when using a cash-out refinance.

For example, 30-40% equity is needed to get 10-20% in cash.

You’ll also need to meet minimum credit score requirements. A conventional cash-out refinance — the most common type — requires a credit score of at least 620.

FHA also has a cash-out refinancing program, which allows a lower FICO score of 600. But be aware that taking out a new FHA loan means you’ll pay for mortgage insurance premium (MIP), including both an upfront fee and monthly mortgage insurance fee. This will increase the total cost of your new loan and eat into your savings margin.

For qualified veterans and service members, another option is to consolidate debt via the VA cash-out refinance.

Unlike other refi programs, the VA cash-out loan lets you refinance 100% of your home’s value. Veterans might qualify even if they don’t have enough equity for a conventional cash-out loan.

Verify your cash-out refinance eligibility (Mar 2nd, 2021)

Other debt consolidation loan options

A different way to tap into your home’s equity and pay off debt is with a home equity loan or home equity line of credit (HELOC). 

A HELOC works as a revolving line of credit with an adjustable interest rate (often based on the prime rate), plus a margin. It’s sort of like a credit card secured against your home — you borrow only what you need at the time you need it, and begin repayment only when there’s a balance owed. 

With a fixed-rate home equity loan, you get a lump sum at closing that you can use to pay off your debts.

Both HELOCs and home equity loans can charge closing costs and/or origination fees. 

“A HELOC is a great option if your primary mortgage is already at a competitive rate or you can’t qualify for a new mortgage currently,” says Sweeney.

In other words, if it’s not a good time for you to refinance, HELOCs and home equity loans offer another route to get lower interest by securing your debts against your home. 

Personal loans (“debt consolidation loans”)

A debt consolidation loan works differently from a debt consolidation refinance.

“It is typically an unsecured personal loan, with fixed payment terms, used to pay off high-interest debt,” explains Bovee. 

“Your interest rate on this loan is likely to be significantly lower than credit cards will charge. But it’s probably not as low as a debt consolidation refinance or HELOC would be,” he notes. 

Bovee adds that a personal loan debt consolidation is a better option if you don’t own a home or don’t have enough equity in your home to borrow against.

Pros and cons of a debt consolidation mortgage  

Debt consolidation can be a smart way to get out of debt faster. But if you slip up after taking out a mortgage refinance, the potential risks are high.

Benefits

The obvious benefit of a debt consolidation refinance is that you’ll save money by lowering the interest rate on your outstanding debts. This could save you a huge amount of money in the long run.

“Say you had four or five credit cards with interest rates in the 18 to 25% range that are at or near their credit limit,” says Bruce Ailion, Realtor and real estate attorney. “Assume you are making minimum monthly payments, too. Not only will you likely never pay these off. You’ll also pay a great deal in interest.”

Now imagine that you consolidated all of these debts into one loan with an annual percentage rate below 4%.

“You would save big money. In fact, the savings you’ll reap on paying less interest could be applied toward the [loan] principal. That means you can pay off the entire debt quicker,” Ailion adds.

Consolidating your debt can also improve your credit score. It helps by lowering your “credit utilization ratio,” which is the percentage of your total credit limit that you’re using at any given time.

In general, the lower your utilization ratio, the better your FICO score.  

Drawbacks

Paying off high-interest credit cards with a low-rate mortgage refinance might sound like a no-brainer. But there are some very real pitfalls to watch out for.

Debt consolidation strategies have a high failure rate. And credit experts say that many who use home equity to pay off credit cards will then run their cards up again — until they’re in even worse shape than when they began. 

Remember: “Unlike unsecured credit card or personal loan debt, mortgage debt is secured [against your home],” cautions Ailion.

“That means you’re pledging your equity as collateral for the money you borrow. If you happen to default and declare bankruptcy, debts that were previously dischargeable are now secured by your equity.”

In a worst-case scenario, a homeowner could refinance their debts then run up new debts so high they can no longer afford monthly mortgage payments. They could face foreclosure and eventually lose their home.

It’s also important to remember that a mortgage refinance involves resetting your loan term. If you were 10 years into a 30-year mortgage at the time of refinance, your remaining term would reset from 20 to 30 years. 

This means you’ll be paying interest for an extended period of time. So despite short-term savings on your higher-interest debt, you could end up paying more when all is said and done. 

Overall, a debt consolidation refinance can be a smart way to pay down debts at a much lower interest rate. But it requires a high level of discipline in making payments to avoid negative consequences. 

Remember, you still owe the money

With any type of debt consolidation loan, the borrower should exercise caution and be extremely disciplined with repayment. That’s especially true with a mortgage or home equity-backed loan, which could put your home at risk if you’re unable to make payments. 

Borrowers sometimes get into trouble because when debt is consolidated, their prior credit lines are usually freed up. It’s possible to charge those lines to the max and be in debt trouble all over again.

Remember, consolidation does not mean your debts have been “wiped out.” They’re just restructured to be more manageable. The real goal is to be debt-free; a refinance or loan is just a means to that end.

Your next steps

Debt consolidation can be a legitimate road to debt-freedom for careful borrowers. But you need to be aware of the potential pitfalls beforehand in order to avoid them and pay down debt successfully. 

  • Seek help to get spending under control
  • Make a higher-than-minimum payment on credit cards
  • Consider zero-interest transfers or personal loans as alternatives

Start by comparing mortgage refinance rates from a few lenders to learn how much you might be able to save by paying off your debts at a lower interest rate. 

Verify your new rate (Mar 2nd, 2021)