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If you have high-interest debt, like credit cards, refinancing for debt consolidation can make it easier to tackle your debt. But there are also risks involved. (iStock)
In almost any comparison, a mortgage APR is lower than a credit card APR. When mortgage rates are low, you may think it’s a no-brainer to use your home’s equity to pay off credit card debt that has a double-digit APR.
But proceed with caution. Refinancing for debt consolidation comes with significant risks, as well as benefits. Let’s examine what it looks like to refinance for debt consolidation.
Refinancing for debt consolidation: How it works
Debt consolidation involves combining multiple forms of debt (credit cards, loans, etc.) into one convenient monthly payment. Consolidation could help you get a lower interest rate, which can help you save money and make it easier to pay down your debt faster.
If you are a homeowner and have enough equity, a cash-out refinance is one option to consolidate debt. With a cash-out refinance, you take out a new loan — either fixed-rate or adjustable — for more than your current mortgage balance. The loan funds first go toward paying off your existing mortgage, as well as any prepaid items (like real estate taxes) and closing costs.
You receive the remaining funds in a lump sum to use as you desire, including to consolidate other debts into a single monthly payment. While refinancing to consolidate debt can simplify your payments and possibly get you a lower interest rate, be aware that tapping home equity to pay off credit card debt means you’ll be turning unsecured debt into debt that’s secured by your home. Defaulting on credit card debt doesn’t put your home at risk. Defaulting on a mortgage does.
Refinancing for debt consolidation works just like any other refinance. You’ll have to apply, qualify, go through the closing process, and pay closing costs.
You should shop around when refinancing a mortgage to make sure you get the best rates and terms possible. If you’ve improved your credit since you took out your first home loan, you may qualify for more favorable terms.
You may save money overall with a cash-out refinance if you can secure a lower APR than you’re currently paying on all your debts. But you may end up with higher monthly mortgage payments if you refinance to a 15-year term from a 30-year term. You need to make sure your budget can accommodate these higher payments.
You can compare cash-out refinance offers from multiple lenders when you use Credible.
Is a cash-out refinance for debt consolidation a good idea?
Whether or not a cash-out refinance for debt consolidation is a good idea depends on your unique financial situation. Consider these factors when deciding:
- Your ability to manage the new mortgage payment — Crunch the numbers to make sure you can afford your new mortgage payments. Ideally, even if your new monthly mortgage payment is higher than your original payment, your total debt payments will drop, leaving you more funds available to put toward your mortgage.
- Your ability to avoid getting into more high-cost debt — While a cash-out refinance can make paying down debt more manageable, if you continue accumulating new debt, you may struggle to pay your new mortgage and other debts. Remember, by refinancing to consolidate debt, you convert unsecured debt into one secured by your home.
- Your ability to qualify for a better interest rate and terms — If you can’t qualify for a lower interest rate, you may end up paying pricey closing costs with little or no real financial benefit.
- How long it will take to realize savings — You should also consider how long you’ll have to pay on the loan until your savings cover the closing costs you paid.
Pros and cons of a debt consolidation mortgage
Like every financial decision, tapping your home equity to pay off high-interest debt has advantages and disadvantages. Before refinancing to consolidate debt, here are some things you’ll want to consider:
Pros of refinancing for debt consolidation
- Loan terms can change for the better. There are two potential ways your loan term could change and benefit you. If you refinance to a longer loan term, you can end up with lower monthly payments that are easier to manage. If you obtain a shorter loan term (with the same or lower APR), you’ll save money by paying off your loan faster and making fewer interest payments.
- You could get a lower interest rate. If your credit or market conditions have improved since you took out your original mortgage, you may qualify for a lower interest rate, which can save you a lot of money over the life of your loan. And you’ll almost certainly get a lower interest rate on a mortgage refinance than you pay on your credit cards.
- Convert a variable rate into a fixed rate. The payments for an adjustable-rate mortgage, or ARM, can be unstable and hard to budget for. If you can switch from a variable to a low, fixed-rate mortgage, you can eliminate the risk of having an interest rate that can suddenly rise significantly.
Cons of refinancing for debt consolidation
- You’ll pay closing costs and other expenses. When you refinance, you need to fund lawyer fees, appraisal costs, and closing expenses.
- Your income must be stable. Because your home is on the line, you won’t want to refinance for debt consolidation unless you’re confident you can afford it. If your income is unstable in any way, you may want to reconsider refinancing.
- You need to stay put for awhile. Refinancing won’t save you as much money if you plan to move in the near future. You have to live in your home long enough to balance out paying the closing costs.
How debt consolidation can affect your credit score
Debt consolidation’s affect on your credit score depends on a variety of factors.
- Credit inquiries — When you apply for credit, the lender will perform a hard inquiry, which generally knocks a few points off your credit score. But this impact will lessen fairly quickly.
- Average age of accounts — When you open up a new credit account, the average age of your credit accounts drops. The older your credit accounts are, the more your credit score will benefit.
- Credit utilization rate — If you consolidate credit card debt and then close the cards, you’ve reduced how much credit you have available. As a result, your credit utilization rate — which compares your total available revolving credit with how much you’re actively using — could suffer.
- How reliably you pay your mortgage — If consolidating costly credit card debt into a more affordable mortgage payment helps you stay on top of your bills, your credit score could benefit. Payment history is the single most important factor in most credit-scoring models.
You can compare mortgage refinance rates and prequalify without affecting your credit when you use Credible.
5 alternatives to refinancing for debt consolidation
If you decide that refinancing for debt consolidation isn’t the right fit for you, you do have other options to help get your debt under control.
Consolidate with a personal loan
Personal loans can be used for virtually anything, including consolidating debt. If you have strong credit, you may be able to get a low interest rate. Plus, debt consolidation loans are generally unsecured, so you won’t need to risk any collateral.
On the downside, personal loans can have shorter repayment terms (as low as one year), which may be more challenging to pay off. And you’ll generally need good to excellent credit to qualify for the best personal loan rates or a large loan amount. Borrowers with bad credit may have a more difficult time finding the best rates.
0% APR balance transfer credit card
If you qualify for one, you can consolidate card balances onto a balance transfer card with a 0% introductory APR. This can give you an extended period of time (a few months to two years) to pay off your debt without paying any interest. The downside? If you don’t pay off your debt before this introductory period ends, you’ll have to pay interest and balance transfer fees on the remaining credit card balance.
Retirement account loan
You may be able to borrow money from your 401(k) — without having to worry about a credit check. The interest rate is generally pretty low on retirement account loans, and your payments will be deducted from your paychecks.
But borrowing from retirement funds should always be your last resort. Once you remove funds from a retirement account, you lose the power of compounding interest and your money isn’t working to help secure your retirement. Also, you could face an early withdrawal penalty and income taxes if you fail to repay the loan on time.
Tap into savings
If you’ve been saving for a rainy day, using that money to pay down your debt may make your financial life a lot more simple. As hard as it can be to watch your savings disappear, the faster you pay down your debt, the less you’ll spend in interest and the sooner you can repair your credit. Just make sure you still have some emergency savings in case unexpected costs like auto repairs arise.
Debt management plans
A debt management plan with a credit counselor can help you consolidate unsecured debt through their agency. That way, you can make just one payment to the agency instead of multiple creditors. In some cases, these agencies can also negotiate lower interest rates with your creditors.
Debt management plans can have both upfront and monthly fees, but those fees may be worth paying if you can avoid debt settlement or bankruptcy. And keep in mind that debt settlement can affect your credit. Finally, be wary of debt settlement scams. Use the federal Department of Justice list of approved credit counseling agencies to vet any credit counselor you’re thinking of working with.
When you’re ready to refinance your mortgage, Credible makes it easy to compare rates and prequalify for a mortgage refinance in just minutes.