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Refinancing your mortgage to consolidate debt: Pros, cons, and alternative options

Erik J. Martin
The Mortgage Reports contributor

Consolidate high-interest debts to pay them off at a more affordable rate

It’s an unfortunate reality that many Americans are weighed down by debt — whether from credit cards, auto payments, student loans, or another source. 

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

Debt consolidation might mean another, lower-interest personal loan. Or it could mean securing unsecured debts against your mortgage in the form of a home equity line of credit (HELOC) or a debt consolidation refinance. 

It’s important to understand what’s involved with each of these loans — the money-saving benefits as well as the potential pitfalls. 

And with any strategy, shop around carefully based on rates, fees, and closing costs. You’ll save the most by putting a little effort in on the front end to find the best lender for your situation. 

Compare mortgage and refinance rates from major lenders. Start here (Nov 14th, 2019)

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,” says Sweeney.

High-interest debt typically comes from unsecured lending sources like credit cards. “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.)

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

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 refinance or personal loan can simplify matters and save 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

Pros and cons of debt consolidation

  • Pros
    • Secure a lower interest rate to help pay off large debts
    • Reduce your monthly payments
    • Raise your credit score 
  • Cons
    • High rates of payment failure
    • Extended loan periods can mean you pay more over the full term
    • Default could put your home or other assest in jeopardy

Bruce Ailion, Realtor and real estate attorney, explains how debt consolidation is beneficial.

“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. Assume you are making minimum monthly payments, too,” says Ailion. “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 at an interest rate between 4 and 9%.

“You would save big money. In fact, the savings you’ll reap on paying less interest could be applied toward the 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.  

On the other hand, 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. 

The bottom line here is that debt consolidation strategies can work, but only if you’re committed and very disciplined in following your payment plan. 

Debt consolidation refinance: A low-interest payment plan

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.

Imagine: With today’s low mortgage rates, you could potentially pay off credit card debts carrying 18-25% interest using a mortgage loan carrying sub-5% interest. 

“Say you are able to refinance your primary mortgage at a rate that is sufficiently lower to cover the costs of refinancing. If so, this is likely your best option to consolidate debt” –John Sweeney, head of wealth and asset management at Figure

Here’s how it works: A debt consolidation refinance involves resetting your mortgage at a fixed lower rate available today. At closing, you pull out equity from your home that is used to pay off your outstanding non-mortgage debt. 

Of course, refinancing comes with closing costs, just like the original mortgage. These often come out to 1-5% of the total loan — 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. 

Depending on your term and rate, the major benefit is obvious. You’ll have a lower monthly payment than you would have paid if you didn’t consolidate your debt or touch your mortgage. 

Alternative methods: Home equity financing (HELOCs and home equity loans) 

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 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. 

Drawbacks to debt consolidation mortgages and equity financing

Paying off your credit cards or other debt with a low-rate mortgage refinance might sound like a no-brainer. But there are some very real pitfalls to watch out for if you go this route. 

“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 other words, if you default on your payments, your home could be on the line. 

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. 

Alternative methods: Personal loan debt consolidation 

A debt consolidation loan works differently.  

“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.

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The elephant in the room: 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. 

“The best candidates for any of these options, including a debt consolidation personal loan, are financially educated and disciplined people. Any of these strategies can be dangerous for financially irresponsible borrowers just seeking payment relief and more debt.” –Bruce Ailion, realtor and real estate attorney

That’s because, when debt is consolidated, your prior credit lines are usually freed up. If you’re not careful, you can charge those lines to the max again 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. Being aware of the potential pitfalls beforehand will help you 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 refinance rate. Start here (Nov 14th, 2019)