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​​Debt consolidation mortgage​: Do it safely, or don’t do it

Peter Miller
The Mortgage Reports contributor

In this article:

While refinancing high-cost debt with low-cost mortgage borrowing might seem like a no-brainer, you still need to use caution.

  • Remember that you still have to pay the debt. Debt consolidation is only designed to make your repayments more manageable. It does not eliminate your debt.
  • Don’t use your home equity unless you are very disciplined and did not acquire the debt through financial mismanagement.
  • If you do decide to use your home equity to help you consolidate debt, you can do this in one of three ways: a cash-out refinance, a fixed rate second mortgage, or a home equity line of credit (HELOC). All three have pros and cons, so evaluate all options before you make your decision.

Get debt under control this year — maybe

With a debt consolidation mortgage, now may be the time to refinance your home and pay off other accounts. Depending on your equity, it’s goodbye credit card balances, car loans, and even student debt. Do it right and your monthly costs can fall significantly.

Verify your new rate (Dec 10th, 2018)

Home equity up nationwide

The Federal Reserve reports that at the end of the second quarter, homeowners accumulated real estate equity worth $13.9 trillion. That’s a lot more than it used to be, in part because home values in most areas have been rising.

According to the National Association of Realtors, in October, existing home prices nationwide rose for the 68th straight month of year-over-year gains.

Debt consolidation mortgage advantages

Not only have homeowners generally gained a large amount of equity, they can also access that money. Today’s mortgage rates are around 4 percent, a rate generally below the cost to finance cars, student debt, and especially credit cards.

Cash-out refinance or home equity loan? The answer might surprise you

If you’re repaying a mortgage at 4 percent and a credit card at 16 percent, the rate difference is obvious.

And pitfalls

While a lower rate is what you want, it’s not the only consideration. If you have a $1,000 debt, and repay it over five years at 16 percent, the total interest cost will be $459.20. The monthly payment will be $24.32.

Alternatively, if you have a $1,000 debt at 4 percent, and repay over 30 years, the monthly payment will be just $4.77. However, over 30 years, the total interest cost will be $717.20.

Be careful out there. We’re looking for not only a lower rate, but also a loan which is structured to our advantage.

How much can you borrow?

If you have a property worth $400,000, and the outstanding loan balance is $200,000, you have a loan-to-value ratio of 50 percent. Most lenders are fairly comfortable loaning as much is 80 percent, and some will go even higher.

In this example, the homeowner can borrow an additional $120,000 ($400,000 x 80 percent = $320,000. $320,000 less $200,000 = $120,000) if qualified.

Cash-out refinance, fixed second mortgage or line of credit?

You have three options for using home equity to pay off more expensive debt: the cash-out refinance, the fixed second mortgage, and the home equity line of credit (HELOC).

Cash-out refinancing

Consider cash-out refinancing only if you can significantly improve on the terms of your current mortgage. That’s because lenders charge extra for cash out, and that fee applies to the entire home loan, not just the cash out. Because you’re borrowing enough to pay off your existing home loan plus more, this is the most expensive financing option.

4 alternatives to a cash-out refinance

The interest rate, however, is generally the lowest of the three choices. It might be the best option if you plan to take out a lot of cash, but probably makes little sense to get just a few thousand.

Fixed second mortgage

For many, this loan is a perfect choice. Its interest rate is higher than that of a first mortgage, but you only pay fees on the cash you need, not to replace your current mortgage as well.

$65k in student loans: Should you take out a second mortgage?

And you can choose a fixed interest rate and a shorter term (anything from 5 to 30 years), so you are not using long-term financing to repay smaller amounts. The fees are lower than those of cash-out refinancing, but higher than those of a HELOC.

HELOC

The home equity line of credit is secured by your house, but functions kind of like a huge credit card. With lower interest than a credit card, of course.

For smaller amounts, the HELOC offers the advantage of the lowest setup cost — even zero in many cases. Its initial interest rate may also be lower.

HELOC or fixed home equity loan? Which is better?

However, HELOCs come with significant disadvantages. First, if the reason you’re in over your head with debt is credit card abuse, getting a mortgage that’s like a giant credit card is a bad idea.

Second, the interest rate is not fixed, so your payments can fluctuate. And finally, the HELOC allows you to draw funds for part of its term (say 5 years for a 15-year loan), and then amortizes the balance over the remaining term (in this case, 10 years). That can cause your payment to shoot up.

The elephant in the room: You still owe the money

While refinancing high-cost debt with low-cost mortgage borrowing might seem like a no-brainer, the borrower still has to use caution.

Refinancing your non-housing debt with a mortgage does not mean your debts have been “wiped out.” You’ve restructured the debt and made it more manageable, but it still exists. The real goal is to be debt-free.

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Credit counselors estimate that over 80 percent of those who use home equity to clear credit card debt run their cards up again and end up in worse shape. So don’t use home equity unless you are very, very disciplined and did not acquire debt through financial mismanagement.

Debt consolidation mortgage alternatives

If you have any doubt at all about your ability to pay off your debt and stay out of trouble, get professional help. Reputable non-profit credit counseling firms can help you budget, pay off your debt and may even get your interest rates reduced.

Mortgage with a Chapter 13 bankruptcy

If you have a lot of non-mortgage debt, and would rather not refinance your home, there is an alternative. It may not be easy, but dig in your heels, create a budget, cut costs, pick your smallest debt, and pay that one off.

That will eliminate a monthly payment. Then repeat the same process with the remaining debts that you have. It may take a long time, and it may be hard, but paying your way out of debt is a great way to improve your financial situation and raise your credit score.

What are today’s mortgage rates?

Whether you choose a cash-out refinance, a HELOC or second mortgage, current mortgage rates are still stable and low. Compare the costs of these programs and restructure your debt now.

Verify your new rate (Dec 10th, 2018)