If you own a home and are looking for ways to consolidate debt, a cash-out mortgage refinance can be a good option. By doing a mortgage refinance to consolidate debt, you can simplify your finances. Depending on interest rates, you could also save money by moving to a lower-rate mortgage.
With that being said, going through with a mortgage refinance for debt consolidation does carry some risks. It can also be more challenging to qualify for a mortgage than other loan types. Read on as we’ll go through the benefits and downsides of using a mortgage for debt consolidation, as well as the costs and requirements of doing so.
Types of loans for a debt consolidation refinance
A debt consolidation refinance typically requires you to do a cash-out refinance. With this type of refinance, you get a new mortgage loan that has a balance greater than your existing home loan. The difference is then used to pay off the balance of your other loans.
For example, let’s say you have a current mortgage balance of $100,000 and you decide to do a cash-out refinance for $150,000. Assuming no closing costs, $100,000 of the new loan will be used to pay off the existing home loan, while the remaining $50,000 can be used to pay off other debt, such as student loans, car loans, and credit cards.
With that said, there are different types of loans that can allow you to do a cash-out refinance. Some examples of these mortgage programs include:
- Conventional
- Federal Housing Administration (FHA)
- Veterans Administration (VA)
- Reverse mortgage
Benefits of a debt consolidation mortgage
Doing a cash-out refinance to consolidate debt can yield many financial benefits. You could save money on interest charges as well as simplify your finances by reducing the number of monthly payments you need to make.
Pay off high-interest debt
The average rate for a fixed-rate 30-year conventional mortgage is currently hovering below 8%. Other types of debt, on the other hand, can have much higher interest rates. For instance, student loans, auto loans, and credit card debt can have rates that range from 10% to 30% or more.
By using a mortgage refinance to pay off higher interest rate debt, you’ll be able to save on interest charges. Additionally, with a lower interest rate, a larger portion of your payments will go toward the principal balance of the loan, which can further help with a faster loan payoff.
Simplify your finances
By consolidating debt, you can reduce the number of monthly payments you have to make. Doing so can not only simplify your finances, but it can also reduce the likelihood that you’ll miss a payment. This can indirectly help your credit score.
Eliminate private mortgage insurance
In addition to being able to pay off debt, you could eliminate private mortgage insurance (PMI) from your monthly payment if it’s currently part of your current mortgage. You’ll typically need at least 20% equity in your home. You can calculate the amount of equity you have by taking your loan balance and dividing it by the value you get from a home appraisal.
Downsides of using a mortgage refinance for debt consolidation
While using a mortgage to consolidate debt can have many benefits, there are also some risks to consider.
You risk foreclosure if you miss too many payments
Since a mortgage uses your home as collateral, defaulting on the loan could result in the bank foreclosing on you. Foreclosure processes and timelines vary by state, but this is not something you’ll typically need to be concerned about until you are at least 120 days delinquent.
If you know you’ll fall behind on your payments, it’s a good idea to contact your lender. Contrary to what many may believe, this can actually work in your favor. Lenders are not in the business of foreclosing on homeowners as it is an expensive and time-consuming process, so banks actually want you to continue making payments.
If you contact your lender, they may offer you a modified payment plan. This can include temporary payment deferrals where no late payments will be reported or a new loan agreement with lower monthly payments for a short period of time.
You’ll need to pay closing costs to do a mortgage refinance
In order to do a mortgage refinance, you’ll need to pay certain fees. These typically range from 2% to 6% of your loan amount. Closing costs cover a variety of items such as an appraisal inspection, a title search, escrow fees, government recording fees, flood zone certification fees, and more. Costs may also vary depending on the type of loan you are getting, such as a conventional, FHA, or VA loan.
One thing to note is that while some lenders may advertise a no-closing-cost loan, it typically only refers to the upfront fees. These types of mortgages often come with higher interest rates, which can result in you paying more fees over the long run.
It can be more difficult to qualify for a mortgage refinance
Compared to other types of loans, a mortgage refinance can be more difficult to get. This is because multiple aspects of your loan application are evaluated. If any of them do not meet the lender’s requirements, you may not qualify.
Some examples of items that are commonly evaluated include your income, expenses, debt-to-income ratio, appraisal report, loan-to-value ratio, and more.
You could pay more interest in the long run
In addition to the interest rate, you should consider the dollar amount of interest charges you’ll be paying. You should compare the interest you’d be paying on your loans before and after the mortgage refinance debt consolidation.
In some cases, you could be paying more interest charges even with a lower interest rate. This can happen if the mortgage refinance has a longer loan period. In other words, while you might be paying a lower interest rate, you could also be paying it for a longer period of time.
Requirements to do a cash-out refinance
You’ll have to meet certain eligibility criteria for a mortgage refinance to be an option. Qualification requirements can vary depending on the lender and type of loan you’re getting, such as whether it is a conventional mortgage, FHA, VA, or USDA loan.
However, regardless of the type of loan and lender you choose, below are the most common items you’ll be evaluated on:
Credit
In addition to your credit score, lenders can evaluate the details of your credit report. This can include things like the number and type of late payments, whether you have any bankruptcies or collection accounts, the type of accounts you currently have, how much debt you’re carrying, and more.
Similarly, the minimum recommended credit score can vary depending on the type of loan and lender you choose:
- Conventional loan: 620 and above is recommended
- FHA: As low as 500 is acceptable
- VA: 580 recommended, but varies by lender
Income
Your income is another critical portion of your loan application because it tells lenders if you have the ability and capacity to afford the monthly mortgage payments. Lenders evaluate how much income you’re currently earning, and the type, and stability of the earnings.
Self-employed borrowers (which can include gig workers and contractors) are typically seen as higher-risk sources of employment, so lenders may take an average of your earnings over the past two or more years.
Once your income is evaluated, lenders will compare it to your debt. Payment information from your credit report is often used to calculate your debt-to-income ratio. This is a critical figure used in determining whether you can get approved.
Depending on the loan program you choose, it’s recommended to have the following DTI ratios:
- Conventional loan: 50% maximum, but 45% and below is recommended
- FHA: 57% maximum, but 40% and below is recommended
- VA: 41% and below is recommended
Property
Since your home is used as collateral for a mortgage loan, lenders will evaluate it to determine its condition and value. This is typically done with an appraisal. With most types of loans, your property must be free of any health or safety hazards. This includes active construction or renovation projects. Depending on the type of loan you get, you’ll also need to have a sufficient amount of equity to get approved for the loan.
Assets for Reserves or Cash to Close
With a mortgage refinance, you’ll need to have some way to pay for the closing costs associated with getting the loan. Depending on the type of loan you get and the amount of equity you have in your home, you may be able to include these fees with your loan. Another option would be to pay for it separately from a checking or savings account.
In some cases, you may also need to demonstrate an adequate amount of reserves, which can range from 0 to 24 months, calculated using the new mortgage loan’s monthly payment amount.
Alternatives to a debt consolidation mortgage refinance
If you can’t get a mortgage refinance, you can consider home equity loans, home equity lines of credit, or personal loans. Each has its own set of pros and cons.
Home equity loan
With a home equity loan, you can get a lump sum of funds that can be used to pay off your other debt. A home equity loan is typically a second mortgage on your home, so you’ll have an additional monthly mortgage payment to make. Interest rates are typically fixed with common repayment terms ranging from 10 to 20 years.
Home equity line of credit (HELOC)
A HELOC is similar to a home equity loan but gives you a revolving line of credit. This allows you to draw funds on an as-needed basis up to your maximum credit limit. One downside, however, is that in exchange for this added flexibility to draw additional funds, rates are typically variable.
Personal loan
Personal loans as another method to consolidate your debt. Personal loans typically have higher interest rates, lower loan amounts, and shorter repayment terms. This is an unsecured debt that does not use your home as collateral and can be easier to get approved for if you can afford the monthly payments.
Should you consider a debt consolidation mortgage?
A debt consolidation refinance can simplify your finances and save you money. You’ll be able to eliminate high-interest debt like student loans, auto loans, credit card debt, and other unsecured debt. However, you’ll need to be sure you can afford the new monthly mortgage payment. A mortgage refinance uses your home as collateral, and missing too many payments on your new loan could result in you losing the home to foreclosure.
