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If you own your home, you may be able to use a cash-out refinance to pay off high interest debt. However, there are benefits and drawbacks to using your home's equity to consolidate and pay off other debts.
It's important to understand both your current financial situation and your goals to determine whether it's the right decision for you.
What Is a Cash-Out Refinance?
A mortgage refinance loan allows you to replace your current mortgage loan with a new one. Many people refinance their mortgage loan to get a lower interest rate and monthly payment. But as the principal amount of your loan goes down and the value of your home appreciates, a cash-out refinance also allows you to tap some of the equity you've built.
For example, let's say you currently have a $250,000 mortgage balance on a home worth $400,000. Many lenders will let you borrow up to 80% of the home's value, so you could potentially refinance your loan for up to $320,000.
The difference between the new loan amount and the original loan balance is what you'd receive in cash. You can use that money for just about anything you want, including:
- Debt consolidation
- Home improvements
- Emergency expenses
- Retirement savings
- Education savings
- Other major expenses
Just because you own a home, though, it doesn't mean you're eligible for a cash-out refinance. For starters, you'll need to have enough equity in your home to meet lender requirements—such as the 80% loan-to-value ratio.
Lenders will also consider several other factors, including your credit score, credit report items, debt-to-income ratio, income, job security and more.
It's possible to get a cash-out refinance with bad credit, but not all lenders specialize in working with subprime borrowers, and you may need to meet other eligibility criteria to qualify for a loan.
Risks of Using a Cash-Out Refinance for Debt
One of the primary reasons to consider using a cash-out refinance to consolidate high-interest debt is that you can typically get a much lower interest rate on a mortgage loan than you can with credit cards, personal loans and other expensive credit options.
However, there are some potential pitfalls that can have a significant impact on your financial well-being:
- Threat to your home: When using a cash-out refinance to consolidate other debts, you're essentially converting unsecured debt to secured debt. Your monthly mortgage payment will go up, and if you can't make your payments, you could risk default and foreclosure. In contrast, defaulting on a credit card or personal loan may harm your credit, but it won't cause you to lose your home.
- Closing costs: The fees involved in refinancing a mortgage loan can amount to 2% to 6% of the loan amount. You can typically choose to pay those costs upfront or roll them into the new loan. If you pay upfront, the savings you gain from consolidating high-interest debt will need to be more than the closing costs. If you roll them into the loan, it could reduce how much you qualify for. What's more, you'd end up paying interest on the closing costs for as long as you have the loan.
- Impact on your credit score: Mortgage lenders run a hard credit inquiry on your credit reports during the application process, which can knock a few points off your credit score. Also, adding a brand-new loan to your credit report will lower the average age of accounts, which could also negatively impact your credit score.
As you consider your options, it's important to weigh both the pros and cons to determine the right fit for you. Take some time to run the numbers to ensure it's the best move for your situation.
Alternative Ways to Pay Off Debt
If you're not sure about using a cash-out refinance to get out of debt with other lenders, here are some alternatives to consider:
- Debt consolidation loan: You can use a personal loan to consolidate and pay off other high-interest balances. While the process is similar to using a cash-out refinance loan, personal loans are typically unsecured, so you don't have to worry about losing your home if you default.
- Balance transfer credit card: If you have credit card debt, you may be able to apply for a new card with an introductory 0% APR promotion and transfer that debt to the new card. A balance transfer card can be incredibly appealing because it can allow you to eliminate debt interest-free—as long as you pay off the transferred debt before the introductory 0% APR ends. Also keep in mind that you'll usually pay a 3% to 5% fee of any amount you transfer.
- Ask for a lower interest rate: If you have good credit and you've always had a positive payment history on your credit card accounts, call your credit card issuers and ask for a lower interest rate. If you're eligible, it could save you money on interest and make it possible to become debt-free sooner.
- Use the debt snowball or avalanche payoff method: The debt snowball method involves paying the minimum amount on all of your debts but focusing on paying more toward the debt with the smallest balance first. Once you've paid off that account, apply its payment amount as an extra payment to your next-smallest balance and continue that process until your last debt is gone. Another way to accelerate your debt payoff is using the debt avalanche method, which targets your balance with the highest interest rate first and usually saves you the most money over time.
Make Sure Your Credit Is Right First
Whether you choose a cash-out refinance, debt consolidation loan, balance transfer credit card or any other option, it's important to ensure your credit is in good shape.
Check your credit score to see where it stands, and look for areas that need improvement. You may also choose to review your credit report for more context, and also look for potentially inaccurate information that could be impacting your credit score negatively.
If your credit isn't where you want it to be, take steps to improve your credit score before you apply for a new loan. This process can take some time, but the benefit of getting a lower interest rate could save you hundreds or even thousands of dollars.