Taking a cash-out mortgage for debt consolidation is a great idea — sometimes.
Converting all your monthly payments to one bill can simplify your life. Plus, if your credit card or car loan is carrying a high-interest rate, you might be able to benefit from a lower mortgage interest rate.
Debt consolidation using home equity is one option to consider. Let’s explore your cash-out refinance options for debt consolidation.
What is a cash-out refinance?
A cash-out refinance involves taking out a new mortgage to replace your existing mortgage. The new mortgage is for a larger loan amount than what you currently own on your home loan. You’ll receive the difference in cash that can be used for whatever you like, including to pay off other high-interest debt you may have.
How to get a cash-out refinance for debt consolidation
Let’s explore how you can move forward with a cash-out refinance.
Requirements for a cash-out refinance
If you’ve decided that a cash-out refinance is the right move for your debt consolidation needs, the process starts by making sure you meet the requirements.
In order to move forward with a cash-out refinance, you’ll need to:
- Have more than at least 20% equity in the home
- Have a credit score of at least 620
- Have a debt-to-income ratio of 43% or less
- Be willing to submit to a new appraisal
If you meet those basic requirements, then you may be able to obtain a cash-out refinance.
Step-by-step guide to getting a cash-out refinance
The process of getting a cash-out refinance is very similar to getting a traditional mortgage. Here’s a breakdown of the steps you’ll need to take:
- Shop around to determine which lender is offering the best rates
- Submit an application with the best lender for your situation
- Provide all requested documents, including your pay stubs, W-2 forms, and tax documents
- Agree to a home appraisal
- Wait for the loan underwriter to review your documents and check your credit report
- If approved, all that’s left is to sign your closing documents
If all goes well, your cash-out refi should move forward within a few weeks. Depending on the lender, you may need to pay your closing costs upfront. If that’s the case, be prepared to bring that money to closing.
Pros & cons of using a cash-out refinance for debt consolidation
Every financial product has advantages and disadvantages. Here’s what to know about using a cash-out refinance for debt consolidation.
|Possible to lock in a lower rate on your loan balances||You’ll likely have a higher monthly mortgage payment|
|Paying off revolving debt could improve your credit score||Closing costs can add up quickly|
|The right refinance could leave more room in your monthly budget||You put your home at risk|
|Mortgage interest is tax-deductible||May pay more in mortgage interest over the loan term|
Using a cash-out refinance for debt consolidation
A cash-out refinance — sometimes described as a debt consolidation mortgage — is one relatively popular way to get debt under control.
Because a cash-out refinance loan is secured by your home, it’s important to understand that it does come with high stakes.
“If you do use home equity and then get more debt, you put your home at risk,” says Scott Halliwell, a certified financial planner with USAA.
But he admits that sometimes life throws out unexpected things such as medical bills, and not everyone who needs debt consolidation does it because of bad debt.
“Through no fault of their own, sometimes people face a financial train wreck. Sometimes, a debt consolidation loan can help them out,” he says.
But for those who got themselves into this financial trouble by racking up credit card debt to buy bigger and better things, then he warns that debt consolidation will not help unless bad spending behaviors and attitudes are changed.
“People can change. But that normally requires some kind of life change such as they get a second income with a spouse, they get an inheritance, or they get a new job with a big pay increase. Those events become the catalyst to fix their spending problem,” he says.
Run the numbers of a cash-out refinance before jumping in
The first thing Halliwell suggests borrowers do is call their current lender and get an amortization table. Many of these tables are available online now, too. This can help you understand the long-term costs of a refinance.
“It can be very valuable to start there and look at your current loans. You can figure out if you leave the current loan alone or you consolidate and how much it will cost you or save you,” he says.
He also said talking to a financial planner, your accountant or even someone in your family who understands finances is a good step to take before signing any new loans.
“At least this way, you are making some level of an informed decision. Know what the financial ramifications are instead of just knowing the payment plan,” he says.
Halliwell would only encourage someone to get a debt consolidation loan if it results in paying less interest over time. For instance, you probably wouldn’t want to consolidate a car loan that you’ve been paying on for four years and only have one year left.
“Most of the car payment is now going toward principal. You don’t want to stretch that back out to a 30-year loan,” he says.
Evaluate your reasons for getting a cash-out refinance
Enrica Bustos, a former housing counselor at Adams County Housing Authority in Commerce City, Colorado, feels that using the equity in your home to pay off credit cards is a bad thing.
“It’s just better to live within your means and pay off those credit cards one at a time,” she says.
She feels that the equity of your home should only be used in extreme cases, like a medical emergency or urgent home repairs.
“Everyone wants the biggest and best right off the start. That’s how so many get into financial trouble,” she says. “No one ever realizes that they can work up to that. Debt consolidation loans do allow people to pay off their credit cards. But they can use them again.”
Bustos has seen too many people never cut up those cards and then eventually max them out again.
“Instead of debt consolidation, I recommend doing a crisis budget. They need to pay off one credit card at a time. This way, they don’t touch the equity in their home,” she says.
When she works with credit counseling clients and they are thinking about a debt consolidation loan, she talks with them about the extra costs they will incur especially by doing a refinancing loan.
“They don’t realize they will have to have another appraisal which costs money. They will have closing costs, too. Is paying $4,000 for closing costs to get $8,000 off of your debt really worth it?” she says. “The fine line about debt consolidation is: How will the person go forward? Will they charge up the card again?”
Alternatives to using a cash-out refinance for debt consolidation
When consolidating debt, a cash-out refinance loan isn’t the right solution for everyone. But that’s okay. There are other debt consolidation solutions out there, including:
Home equity loans
If you want to tap into your home’s equity without touching your current mortgage, a home equity loan is an option. A home equity loan is a “second mortgage,” which means you’ll pay it off by making a second monthly payment in addition to your existing mortgage.
Since it’s a second loan, you won’t have to make any changes to your current mortgage. That’s great news if you already have a rock-bottom interest rate on your home loan. You’ll still be able to access your home’s value at the current market rates.
Home equity lines of credit
A home equity line of credit (HELOC) is another type of second mortgage, also tied to the equity you have in your home. Unlike a home equity loan, a HELOC is a new revolving line of credit rather than an upfront lump sum. It works more like a credit card in that you can borrow up to a stated limit.
If you aren’t comfortable using your home as collateral or simply don’t have enough equity built in your home, a personal loan can allow you to access a lump sum of cash that can be used for debt consolidation.
Since these are unsecured loans, they aren’t tied to your home equity but they also carry higher interest rates and lower limits. Still, depending on how much interest you’re paying on your existing debts, they could potentially save you money and you won’t have to worry about foreclosure if you miss a debt payment.
Should you use a cash-out refinance for debt consolidation?
A cash-out refinance is a useful opportunity for homeowners with substantial equity in their homes. If you have enough equity, a cash-out refinance is an option. It’s usually not a good idea to get a cash-out refinance if you will be stuck with a significantly higher interest rate than your current mortgage.
But in some cases, it makes sense. For example, if you have high-interest debt, you might find that the fixed-rate mortgage which comes with your mortgage is more affordable.
Run the numbers before jumping in to determine whether or not this is a helpful option for your debt consolidation needs.
Cash-out refinance FAQs
What are the requirements for a cash-out refinance?
If you want to get a cash-out refinance, you’ll need to have more than 20% equity in your home and a credit score of 620 or higher. Additionally, when you include the new loan, you shouldn’t have a debt-to-income ratio of more than 43%. Be prepared to submit your home to a new appraisal and verify your income.
Is debt consolidation refinance considered a cash-out refinance?
Yes, a cash-out refinance can be used as a debt consolidation refinance. When you pursue a cash-out refinance, you’ll have the option to pay down other debts with the proceeds.
Can you pay off collections with a cash-out refinance?
Yes, you can use the funds you obtain from a cash-out refinance to pay off collections. After your cash-out refinance is complete, you’ll have the freedom to use the funds however you see fit.
When should you not do a cash-out refinance?
A cash-out mortgage refinance isn’t always the right solution for your finances. When you pursue a refinance, you’ll have to pay closing costs to finalize the loan.
Additionally, you’ll need to consider the new interest rate attached to your mortgage. If mortgage rates have gone up, then it might not be the right time to take out a mortgage.
Another consideration is the type of debt you’re hoping to pay off with the funds. For example, consolidating federal student loans is usually not the right move. If you refinance federal student loans, you’ll eliminate the extensive borrower protections available.
Can you refinance a debt consolidation loan?
If you took out a debt consolidation loan, it’s possible to consolidate it with your mortgage loan through a cash-out refinance. But you’ll have to decide if that’s the right choice for your financial situation.
Do you count debt in DTI when consolidation?
When you pursue cash-out refinancing, lenders will look at your debt-to-income ratio. Typically, a DTI ratio higher than 43% will disqualify you from taking out a new mortgage. All of your debt, including the debt you plan to take out, will be included when calculating this ratio.