If you’re trying to pay down debt and you own a home, you may be wondering whether it makes sense to use a cash-out refinance to pay off debt.
There are pros and cons to going this route, and it’s important to understand how the process works to help decide if it’s the right option for you.
Read on to find out how to use a cash-out refinance to pay off debt, the costs involved, the benefits and drawbacks, and other options for repaying debt you owe.
Using a Cash-Out Refi to Pay Off Debt
In mid 2023, household debt (not including mortgages) in the U.S. exceeded $4.7 trillion dollars, according to a report released by the Federal Reserve Bank of New York. It’s no wonder then that individuals are looking for ways to get out from under the debt they owe.
A cash-out refinance for debt consolidation allows you to use the equity in your home to pay off debt by taking on a new mortgage. The new mortgage pays off your old mortgage and it comes with new terms, including a new interest rate that’s potentially lower, and length of time to repay the loan. The new mortgage terms may be better than your original mortgage, but it’s also possible they may not be as favorable.
Here’s a quick course in cash-out refinancing 101 and how it works:
Determine How Much Cash You Need
When you’re considering a cash-out refinance to pay off debt, first figure out how much money you’ll need. To do this, add up all the debts you want to pay off. Include things like credit card and personal loan debt and medical bills.
Determine How Much You Can Borrow
The amount you can borrow with a cash-out refinance depends on how much equity you have in your home. Equity is how much your home is worth compared to how much you owe. Typically, you can borrow up to 80% of your home’s market value.
Here’s an example of how cash-out refinancing works: Let’s say your home is worth $500,000 and you owe $300,000 on your current mortgage. That means your home equity is $200,000. With a cash-out refinance loan, a lender might let you borrow up to 80% of your equity (as long as you qualify for that amount), which is $400,000.
You’ll need to use that $400,000 to pay off the $300,000 you owe on your mortgage and also closing costs. That leaves you with about $100,000 in a cash out refinance for debt consolidation.
First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.
Prepare Your Cash-Out Refinance Application
Your cash-out refinance application is much like the mortgage application you filled out when you bought your house. Lenders will look at and evaluate such factors as your:
• Credit score: Many lenders look for a minimum credit score of 620 for a cash-out refinance
• Debt-to-income (DTI) Ratio: DTI compares your monthly debts to your gross monthly income. In order to qualify for a cash-out refinance, lenders typically look for a DTI of less than 50%.
• Home equity: As mentioned above, you’ll likely need at least 80% equity in your home.
You may need to provide the lender with documents such as bank statements and W-2s.
💡 Quick Tip: Thinking of using a mortgage broker? That person will try to help you save money by finding the best loan offers you are eligible for. But if you deal directly with an online mortgage lender, you won’t have to pay a mortgage broker’s commission, which is usually based on the mortgage amount.
Complete the Closing and Pay Closing Costs
If the cost to refinance a mortgage makes sense for you, and you qualify with a lender, you’ll pay closing costs to cover such fees as credit reports and appraisals. Closing costs may be wrapped into the refinanced loan amount. After you close on the loan you’ll receive your funds.
If You’re Consolidating Debts, Let The Lender Know
It’s possible that your debts may be high enough to preclude you from qualifying for a cash-out refinance. However, if the lender knows you’ll be consolidating debts, they can include those debts in your loan amount for consolidation.
That way you’ll be paying off the debts in one payment with the new interest rate (ideally, a lower one) you received with your cash-out refinance.
Benefits of Cash-Out Refinancing to Pay Off Debt
When you consolidate debts with a cash-out refi, you have just one monthly payment to make. That’s usually more manageable than trying to pay multiple bills all at once.
There are other potential benefits as well.
Consolidating Debts Can Lead to Savings
High-interest debt can be difficult to pay back. Credit card APRs can reach 29.99% or higher, which adds to the amount you need to pay each month. When you consolidate debt with a cash-out refinance, you may save money on interest costs.
Cash-Out Refinancing Can Pay Debts Quickly
When you take out a cash-out refi to tackle the debt you owe, you may be able to pay off certain debts faster than you would have otherwise. You’ll likely be paying less in interest, which could allow you to put more money toward the debt balance.
Impact On Credit Score
Paying off high-interest debts with a cash-out refi could lower your credit utilization rate, which is the amount of credit you’re using. Credit utilization is an important factor in your credit score.
Should You Use a Cash-Out Refinance to Pay Off Credit Card Debt?
Interest rates on credit cards are typically high, and can be more than 30%. The interest rate on a mortgage tends to be much lower. If you can get a lower interest rate to repay your debt, a cash-out refinance could be worth it. However, if you choose this method, be careful to avoid overspending and running up credit card debt again. Changing your spending habits can be critical to staying out of debt.
Drawbacks of Using a Cash-Out Refinance to Pay Off Debt
A cash-out refinance also has some significant disadvantages to consider. These include:
Increased Monthly Mortgage Payment
When you take out a bigger loan amount, you may also end up with a higher monthly mortgage payment. You’ll be responsible for paying that higher amount each month.
Turning Unsecured Debt Into Secured Debt
Another factor to consider is that if you can’t pay back everything you borrow with a cash-out refinance, you could be in danger of losing your home. That’s because a mortgage is secured debt, and your home is collateral for the loan. While that’s true with any mortgage, with a cash-out refinance you are likely borrowing even more money since you’re using the extra cash to tackle debt, which means there’s more for you to repay.
Closing Costs
When you refinance a mortgage, including a cash-out refinance, you need to pay closing costs. These costs can be around $5,000 according to Freddie Mac. However, the size of your loan and where you live can affect how much your closing costs may be.
Cash-Out Refinance vs. Debt Consolidation
With a cash-out refinance, you take out a new mortgage to repay your old mortgage and also get cash you can use for a variety of purposes, including paying debt. With debt consolidation, you combine all your debts into one loan. A debt consolidation loan is not secured by your home; a cash-out refinance loan is.
💡 Quick Tip: Because a cash-out refi is a refinance, you’ll be dealing with one loan payment per month. Other ways of leveraging home equity (such as a home equity loan) require a second mortgage.
Alternatives to Cash-Out Refinance Loans
A cash-out refi isn’t your only option for paying off debt. Here are some other methods to consider.
Home Equity Line of Credit (HELOC)
A home equity line of credit is secured by the equity in your house. It’s similar to a line of credit, so you borrow just what you need when you need it, and you only pay interest on what you borrow. However, if you don’t pay off a HELOC you may be in danger of foreclosure.
Home Equity Loan
With a home equity loan, you receive a lump sum of money and make regular fixed payments. Interest rates tend to be higher than they are for a cash-out refinance, and you will need to pay closing costs.
Personal Loan
A personal loan is an unsecured loan that you can use for almost any purpose, including debt consolidation. These loans generally come with higher interest rates than a cash-out refinance, HELOC, or home equity loan. They also have a shorter term, which means you’ll need to make higher monthly payments. But that also means the loan will be paid off sooner.
Balance Transfer Credit Card
A balance transfer credit card typically offers a 0% introductory rate for a number of months (up to about 21 months) on debt you transfer from another source, which is usually another credit card. There is a balance transfer fee of around 3%, but you won’t won’t owe interest on the balance you transfer. If you have a lower debt amount that you can pay off in a relatively short amount of time, this option might make sense. However, to qualify for the 0% rate, you’ll typically need a strong credit score.
The Takeaway
If you need to pay off high-interest debt and you have sufficient equity in your home, a cash-out refinance can be an option worth exploring. It can give you a lower interest rate, as long as you qualify, which could help you save money. However, keep in mind that you will need to pay closing costs when refinancing, and the terms of the loan, including the length of the loan, will change.
Turn your home equity into cash with a cash-out refi. Pay down high-interest debt, or increase your home’s value with a remodel. Get your rate in a matter of minutes, without affecting your credit score.*
Our Mortgage Loan Officers are ready to guide you through the cash-out refinance process step by step.
FAQ
Can I use a cash-out refinance to pay off both secured and unsecured debts?
Yes. A cash-out refinance can be used to pay off a variety of debts, including secured debts as well as unsecured debts, like credit cards.
Are there any tax implications of using a cash-out refinance for debt repayment?
If you use a cash-out refinance for debt repayment, you won’t owe taxes on the money you receive from the cash-out refi. That’s because the money is considered a loan that needs to be paid back, and not income. At the same time, per IRS guidelines, you typically can’t deduct the interest on a cash-out refinance if you use the money to pay off debt.
What factors should I consider when deciding whether to use a cash-out refinance for debt repayment?
If you have high-interest credit card debt, and you can get a lower interest rate to repay your debt with a cash-out refinance, it may be worth it for you. But first make sure you can change your spending habits to avoid overspending and running up credit card debt all over again.
Also, consider the fact that your monthly mortgage payment will likely be higher with a cash-out refinance. Can you afford that higher amount? And you’ll also have to pay closing costs. Calculate to be sure that the amount of cash you’ll get from the cash-out refi is sufficiently more than what you’ll spend on closing costs.
Photo credit: iStock/fizkes
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