In this article:
- How Can Refinancing Help You Pay Down Debts?
- How to Decide Whether to Refinance
- Can You Use Your Home Equity to Consolidate Debt?
If you're carrying substantial debt, it may be difficult to pay off your balances without taking some significant action. Refinancing your home to pay off your debt is one option, but it's a move that comes with significant benefits and potential downsides that should be considered beforehand.
Generally, refinancing your house to pay down debts might not be a good idea if you'll struggle to afford your new payments or you're unable to get a better rate on your mortgage.
How Can Refinancing Help You Pay Down Debts?
The primary benefit of refinancing your mortgage to pay down debt is saving money in interest: Mortgage rates are generally lower than other types of consumer credit like credit cards and personal loans.
For example, the average interest rate on 30-year fixed-rate mortgages was 6.39% in early May. By contrast, the latest Federal Reserve data lists average interest rates of 20.92% for credit cards and 11.48% for 24-month personal loans. With Americans carrying an average credit card and personal loan balance of $5,910 and $18,255, respectively, according to Experian data, it's plain to see how high interest rates on these balances can add up.
You can refinance your home to pay down debt in one of two ways:
- Rate-and-term refinance: A rate-and-term refinance involves replacing your current loan with a new one that, ideally, carries a lower interest rate. The new loan may also introduce a new repayment term and monthly payment amount, but the principal balance remains the same. A lower payment can provide you with extra cash you can use to pay down debt.
- Cash-out refinance: A cash-out refinance also works by replacing your current mortgage with a new one, but in this case, the refinance loan is larger than the remaining balance on your mortgage. You can use the difference to pay off debts, fund a home renovation project or for virtually any legal purpose. One important distinction is that the larger loan balance usually raises the overall cost of your loan, even if you secure a lower rate.
In summary: When interest rates are low, a rate-and-term refinance can free up room in your budget to make higher debt payments without adding more principal debt to your mortgage. By comparison, a cash-out refinance provides you with a lump sum of cash to pay off debts, but can increase your monthly payments.
How to Decide Whether to Refinance
Refinancing can have serious implications on your finances, so you should proceed carefully before deciding whether to refinance to pay down debt. The most critical detail to consider is the current interest rates on your mortgage and other debts and the new mortgage rate you'll receive if you refinance. After all, it makes little sense to refinance if you'll end up with a considerably higher interest rate.
Here are some factors to weigh as you make your decision:
- Your interest rate: If you qualify for a rate at least 1% lower than your current mortgage rate, a rate-and-term refinance may make sense. However, a minimal rate drop of less than 1% may be too negligible to make a meaningful difference, especially when you factor in closing costs.
- Your current debt level: Refinancing could be worth it if your existing debt and interest rate are so high that the balance is increasing significantly due to interest charges. Conversely, a refinance may not be your best option if your debt level is relatively low—say, a few thousand dollars or less. In that case, following a debt repayment strategy may suffice to tackle your debt.
- Your monthly budget: A cash-out refinance can help you pay off high-interest debt, but it may leave you with a higher mortgage payment. Project your budget post-refinance to ensure you can afford the larger payment, taking into account the debt accounts you plan to settle.
- Refinance closing costs: Closing costs can range from 2% to 5% of a new mortgage loan. These closing costs usually represent thousands of dollars in upfront expenses. Since it takes time to recoup closing costs, refinancing may not be worth it if you plan on moving soon.
- Likelihood you will accrue new debt: Refinancing to pay off your debt isn't a great idea unless you have a plan in place to avoid new debt from building up in the future. Having zeroed-out credit cards can increase the temptation to spend, and it can take some serious planning to avoid ending up right back where you started.
Can You Use Your Home Equity to Consolidate Debt?
Instead of refinancing, you could take out a second mortgage, such as a home equity loan or home equity line of credit (HELOC). These options may provide lower interest rates than other forms of credit. And they can also simplify your financing by consolidating your debt into a single account with one payment, making it easier to manage your debt.
However, home equity loans and HELOCs come with risks to consider, such as:
- Putting your home on the line: Home equity loans and HELOCs require you to put your home up as collateral to secure the loan. If you default on the loan, your lender could foreclose on your home. This risk isn't present with unsecured loans and credit cards.
- Increasing your overall debt: In addition to your primary mortgage, you must make monthly payments on a home equity loan or a new line of credit. In either case, your overall debt is higher, which reduces your disposable income.
- Lowering your home equity: Home equity lending products allow you to tap into your home's equity for funds, effectively reducing your home equity by the amount you borrow.
- Increasing the risk you could end up underwater on your home loan: If you've significantly reduced your mortgage loan balance or your home's value has increased substantially, you may be able to borrow a large sum of money (often up to 85% loan-to-value ratio). However, if you borrow a large amount and home prices fall, you could end up owing more than the house is worth.
The Bottom Line
Ultimately, the decision to refinance your home to pay off other types of debt is a personal one. Refinancing can be a good option if you qualify for a lower rate and you can substantially save on interest costs. It's also important to resist the temptation to take on more debt in the future, which could offset or even negate any financial benefits of refinancing.
Snagging a low interest rate on a refinance will depend on your credit score and other factors. As a general rule, the higher your credit score, the higher your odds of being approved for a refinance with favorable terms. If you haven't done so already, check your credit report and credit score for free with Experian to see where your credit stands. Then, take the time to improve your credit score, if needed, to help you secure a lower interest rate and more favorable terms overall.
