Cashing out equity to pay off debt
Can you use a cash-out refinance to pay off debt? You bet! In fact, a 2021 survey found that debt consolidation is the second most common reason for a cash-out refinance.
Now could be an especially good time to cash-out home equity and pay off debts. Equity levels rose by nearly 30% between 2020 and 2021. And mortgage rates are still low.
Qualified homeowners could substantially lower their debt payments and increase their monthly cash flow using this method.
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How to use a cash-out refinance to pay off debts
The process for a cash-out refinance is similar whether you’re borrowing to pay off debt or for any other reason. The steps are:
- Work out how much cash you need — Don’t borrow more than necessary
- Work out how much you can borrow — Lenders won’t lend you all your equity. Most require that you leave 20% of your equity untouched, which means your refinance loan will have a maximum loan-to-value ratio of 80%. But those with VA loans can sometimes refinance 100% of their equity
- Apply for your cash-out refinance — This is pretty much the same as when you applied for your original mortgage. Expect an appraisal and a thorough investigation of your finances, including your credit score and credit reports. You’ll need to provide bank statements, tax documents and any other evidence the lender demands. Here’s a documentation checklist
- Proceed to closing — Once your mortgage application is approved, the lender will complete the final steps necessary to close your loan. You’ll have some reading and signing to do
- Pay closing costs — Refinance closing costs are typically 2-5% of the new loan amount. You can usually roll your upfront costs into the new loan balance if you wish. But they’ll be deducted from the amount of cash you get at closing
- Funds received and debts paid off — With a debt consolidation cash-out refinance, the debts you elect to payoff will be paid off along with the mortgage being refinanced. Any remaining funds after paying off both the initial mortgage and additional debts will be obtained either via wire transfer or physical check provided from escrow
When you make your application, let the lender know you’ll be consolidating your debts. That may help rather than harm your application.
Extra steps for a debt consolidation refinance
You may be asked to show current statements relating to your debts, and indicate how they’ll be paid off through escrow after closing. Show you’ve thought this through by preparing a summary of your debts, with the total sums owed roughly matching the amount you’re borrowing. If there’s a difference, explain why using a cash-out letter of explanation.
The debts you’ve built up may suggest that you have had problems managing your finances. So also show that you’re determined to take control of those once your existing debts have been paid down.
You might agree to get help from a credit counselor. Or you could build a detailed household budget that reveals areas where you could economize. Although these extra steps take time, it’s not unreasonable to have to show why you won’t be back in the same situation within a couple of years.
Benefits of using home equity to pay off debt
The objective of a cash-out refinance for debt consolidation is to reduce your monthly payments on debts. And you do that by transferring those high-interest debts to your new mortgage, which should have a much lower interest rate.
The most common high-interest debt is credit cards. And CreditCards.com reckons the average rate at the time of writing was 16.13%.
By contrast, the average 30-year fixed mortgage rate at the time of this writing was 3.11% according to Freddie Mac.
Suppose you owe $40,000 in credit card balances. Your typical minimum payment would be $1,200 or 3% of the balance. But let’s say you pay down $1,300 a month to clear your debt.
CreditCards.com’s calculator says it would take you 40 months to pay off that debt and would cost you about $12,000 in interest.
Now, suppose you paid it down using a cash-out refinance. We’ll assume you have a 30-year, fixed-rate loan and will refinance to the same. And that your current mortgage balance is $200,000 while your home is worth $400,000.
Finally, we’ll assume that you’re currently paying a mortgage rate of 4% while your new mortgage rate will be 3.10%.
Now let’s run the numbers using a mortgage calculator. You’re currently paying $955 a month in principal and interest. Once you’ve refinanced, your mortgage balance will be $250,000 (your old $200,000 balance + the $40,000 to pay off your cards + say, $10,000 in closing costs).
The lower mortgage rate on your cash-out refinance means you’ll pay $1,068 each month on your new home loan, just $113 a month more than previously. And you’ll no longer have to pay $1,200 a month in minimum card payments.
All told, that means you're saving around $1,000 per month by wrapping your credit card debt into your new mortgage balance.
Because their interests rates are so high, credit card balances tend to provide the biggest return when you use a cash-out refinance to pay off debt. But other debts with relatively high rates can provide worthwhile but less dramatic savings. So run your own numbers for auto loans, personal loans, and other loans.
Drawbacks of using a cash-out refinance to pay off debt
The first thing to realize about using a cash-out refinance to pay off debt is that you’re not really “paying off” the debt. You haven’t reduced the total amount you owe. You’ve merely changed from one type of loan to another, lower-interest type of loan.
Of course, there are big benefits to this strategy (as shown above). By rolling your high-interest debts into a low-interest mortgage balance, you could potentially save yourself a big chunk of money each month and create more room for savings and daily expenses.
But there are some inherent drawbacks to cash-out refinancing, too:
- You're resetting the clock on your mortgage — Unless you refinance to a shorter loan term, you’ll be paying off your home for longer. Suppose you’ve had your mortgage for 10 years and refinance with a new 30-year loan. You’ll be borrowing (and paying interest) for 40 years. And, in the long run, that’s going to cost you
- You're turning unsecured debt into secured debt — Your car loan is secured on your car. But card debt and personal loans are unsecured. Using a cash-out refinance to pay off debt means you’re putting your home on the line. And, if things go badly wrong, you could ultimately face foreclosure
Some homeowners also run into trouble when they use a cash-out refinance to pay off debt and then run their debts back up again. This can put you right back where you started — but without a cushion of available home equity to protect you.
None of this necessarily means you shouldn’t go ahead with your cash-out refinance. But these are serious points that require due consideration.
Before getting started, make sure you run the numbers, set a strict budget, and stick to it once your debts are paid down. A financial advisor could be a big help here.
Cash-out refinance to pay off debt vs. home equity loan
There are various alternatives to a cash-out refinance to pay off debt. And they can help you side-step some of the downfalls of refinancing.
For example, a home equity loan would slash your closing costs. That’s because those are based on the amount you’re borrowing. And with a home equity loan, you’re not refinancing your entire mortgage.
You also wouldn’t be resetting the clock on your primary mortgage, which might be a smart choice if your current mortgage is largely paid down.
But you would still be turning your unsecured debt into secured debt. Because home equity loans are second mortgages.
Another alternative might be a personal loan.
Those have the advantages of a home equity loan but also leave your debt unsecured. And they often come with low or zero setup fees. But they typically charge significantly higher interest rates than secured loans. So, while you’d almost certainly make savings on your credit cards, they wouldn’t be as big.
We’re talking here about borrowing big sums of money, often with long-term implications. So make sure you weigh your options carefully and choose a strategy that will benefit you in both the short- and long-term.
Cash-out refinance to pay off debt: The bottom line
If you have a lot of high-interest debt eating away at your monthly budget, using a cash-out refinance to pay those debts down can have huge financial benefits.
Not only will you reduce your monthly payments, but you could also free up lots of cash for regular living expenses, saving, and even investing in your financial future.
Make sure you understand the pros and cons before getting started. And, as always, shop for the best interest rate on your cash-out refinance. The lower your new interest rate, the more you’ll save on all your debts.