Being in serious debt is scary. When you can’t make ends meet, you wonder what will happen. Before you let collection calls and judgments take over your life, consider debt consolidation. If your debts are too high for a balance transfer credit card or personal loan, you have other options. One way is with a cash-out refinance. You can use the equity in your home to pay off your debts. We’ll discuss how this works and the advantages/disadvantages of the process.
What is a Cash-Out Refinance?
When you use the equity in your home, you do so with a cash-out refinance. You pay off your current mortgage and take out a new one with a higher balance. Just how much you can take depends on the value of your home. Here’s an example:
You owe $100,000 on your 1st mortgage. Your home just appraised at $200,000. You have $100,000 in home equity. You won’t be able to use 100% of that $100,000, though. Most programs allow up to 80%. So of the $100,000, you can borrow up to $60,000.
If you borrow that amount, you’ll then have a 1st mortgage of $160,000. You’ll pay principal and interest on the amount. The difference between your 1st mortgage balance and the total loan amount is what you can use for debt consolidation.
What is Debt Consolidation?
Debt consolidation occurs when you take out a new loan to pay off existing debt. You consolidate your current loans into one larger loan. In this case, it’s the cash-out refinance. Debt consolidation doesn’t eliminate your debts; instead it moves them around. If you take out a secured loan, such as a mortgage, you put your home up for collateral. Even if you consolidated unsecured debt, it’s not in a secured loan. If you don’t pay the mortgage on time, you stand to lose your home.
How Debt Consolidation Works With a Cash-Out Refinance
Using the equity in your home can help you get control of your debt. You apply for a refinance, just as you would any other loan. Instead of asking for the amount of your current loan, though, you’ll apply for a higher amount. You can figure out how much you need with the following formula:
Outstanding principal balance of 1st mortgage + credit card balances + unsecured debt + secured debt = Total loan amount
Next, you’ll have to see if you have enough equity to cover the amount you need. Again, lenders usually allow up to 80% LTV. With the current value of your home, you can see the maximum loan amount you may receive. In our above example, you’d have $60,000 in equity.
The loan processes the same way as any other mortgage. Lenders look at your credit score, income, assets, and liabilities. They determine your debt ratio and how likely you are to pay the mortgage back. Once approved, you close on the loan. The difference occurs at the closing. You aren’t just paying off a mortgage and taking out a new one. You took equity out of the home. How the lender handles the equity depends on the lender. There are 2 ways the lender may handle it:
- If your debt ratio is too high with the current debts, they’ll pay your debts. They disburse the equity funds right at the closing. This way they know the debts are paid.
- If you qualify for the loan with the higher debt ratio, they may disburse the funds to you. In turn, you pay your creditors.
Once you or the lender pays the creditors, you consolidated your debt.
Things to Keep in Mind
This might all sound like a great plan. You take cash out of your home, which you earned, and pay off your debts. But, there are some things you should consider:
- You are borrowing the money for a longer period. You’ll pay more interest. This means your debt costs you more in the end. Depending on the loan’s term, you could extend it up to 30 years.
- Mortgages cost money. Lenders may charge origination fees, processing fees, title fees, and closing costs. Mortgages often cost as much as 5% of the loan amount.
- You put your home at risk for loss. If you default on the loan, the lender can take your home. Credit card debt is unsecured debt. The worst creditors could do is put a judgement on you, but you’d still have your home.
A cash-out refinance might be the right option for you, but you should keep these things in mind when deciding.
How to Know if a Cash-Out Refinance is Right
Since you are taking money out of the largest investment you have, you should ask yourself the following questions:
- Is the interest rate lower than what you were paying? It doesn’t make sense to consolidate the debt if you’ll pay a higher interest rate. Combine that with the longer term and you would definitely overpay on interest.
- Will your mortgage payment increase less than the total payments you make now? The goal is to save money by consolidating debt. If you won’t save money, it won’t make much sense.
- Can you stay out of debt? This is a big concern. If you turn around and rack up your credit cards again, you’ll be right back where you started. While you shouldn’t close your credit cards, you also shouldn’t use them. Put them in a safe place and forget they exist.
Does a Second Mortgage Make More Sense?
A cash-out refinance isn’t the only option for debt consolidation. If you have the equity, you may be able to take out a 2nd mortgage. Borrowers usually take out a home equity loan or line of credit. How do you decide which is right for you? Here are some things to consider:
- What are interest rates at right now? Will your new interest rate be lower than the interest rate on your 1st mortgage? If so, it makes sense to take advantage of the 1st This way you can write off all of your interest on your taxes. Plus, you’ll only have 1 bill to pay each month.
- What are the costs? A home equity loan or line of credit can be cheaper than a 1st Try negotiating closing costs with your lender to get the cost of the 1st mortgage down. If the costs are too high, a 2nd mortgage might make more sense.
- How well do you qualify? A 2nd mortgage is often easier to obtain than a cash-out refinance. If you have a lower credit score or higher debt ratio, you may opt for the 2nd
Finding a Lender for a Cash-Out Refinance
Finding a lender for the cash-out refinance is half the battle. The right lender will save you money and help you through the process. Don’t use the first lender you find. We recommend you shop around with at least 3 lenders. Obtain a pre-approval from each lender. This way they will give you a full quote including the cost of the loan. You can then compare the offers to determine which one is right for you.
Don’t assume you have to pay origination fees or discount points. Shop online and in your area. Ask different lenders what they charge. If one lender tells you that you are too risky, try another. Each lender has a different threshold for risk. You can even ask for a no-closing cost loan. This may inflate your interest rate half of a point, but it may be worth it if you plan to stay in your home for a long time.
If you aren’t sure where to shop, ask around. See who friends and family used. You can also look around online. Read reviews to see what others thought of certain lenders. Sometimes online lenders have the lowest rates and fees because they don’t have any overhead.
The Bottom Line
Consolidating debt with a cash-out refinance may be a suitable choice for you. Weigh all of your options before deciding. If you decide it’s your best option, find the right lender. Ask about your different options including interest rates and loan terms. Take the option that is most affordable but that doesn’t stretch your debt out too much. This way you don’t overpay for debt that put you in over your head.