Cash-out Refinancing for Debt Consolidation
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Every month, you pay your mortgage, credit card bills, car loan and student loans. Wouldn’t life be easier if you just had to make one payment each month? Especially if all those debts could be consolidated into one loan with a low-interest rate?
The average homeowner gained more than $15,000 in home equity over the past year, and mortgage rates are significantly lower than credit card interest rates. As such, homeowners may be wondering whether a cash-out refinance for debt consolidation is a smart money move.
What is cash-out refinancing?
A cash-out refinance is a refinance of your existing mortgage loan. It differs from a traditional refinance in that you aren’t simply refinancing your current mortgage to take advantage of a lower interest rate or move from an adjustable-rate mortgage to a fixed-rate mortgage. Instead, your new mortgage is for a larger amount than your existing loan. Proceeds from the new loan are first used to pay off your existing mortgage, plus closing costs for the new loan. You receive the excess amount in a lump sum.
The money you receive from a cash-out refinance can be used for almost any purpose, including home repairs, education expenses or starting a business. But many borrowers use a cash-out refinance to consolidate other debts, including credit cards, student loans, and car loans.
Because cash-out refinancing takes advantage of the equity you’ve built up in your home, the amount you can borrow depends partly on how much equity you have. Your home equity is the difference between the value of your home and your current mortgage balance. The amount you can borrow depends on loan-to-value (LTV) limitations. LTV is calculated as the amount of the mortgage, divided by the home’s current market value.
Adam Smith, president of the Colorado Real Estate Finance Group said LTV limits vary based on the type of loan you use. “Seventy-five percent LTV is a safe number,” he said. But it can go higher. The actual guidelines are 80% for a conventional loan, 85% for an FHA loan or 100% for a VA loan.
For example, say a homeowner — let’s call him Steven — bought his house five years ago for $160,000. It’s now worth $200,000, and his loan balance is $100,000. So Steven has $100,000 of equity in his home. However, unless Steven is eligible for a VA loan, he wouldn’t be able to borrow the full $100,000 of home equity. With a conventional loan — a loan that conforms to guidelines established by Fannie Mae or Freddie Mac — he would likely be limited to tapping up to $60,000 of his available equity. In other words, his new loan would be limited to $160,000, or 80% of the value of his home.
Using cash-out refinancing to pay off debt
Many consumers have a variety of debts, from mortgages to car loans, student loans, and credit cards. Doing a cash-out refinance won’t reduce the amount of debt you owe, but it can help you save on interest and perhaps lower your monthly payments.
This is because interest rates on mortgages are typically much lower than those for credit cards. For example, as of April 19, 2018, the U.S. weekly average for a 30-year fixed rate mortgage was 4.47%. But the average credit card interest rate for the same week was 16.65%.
What does that mean in real dollars?
Let’s say Steven has a credit card with a balance of $10,000 at an interest rate of 16.65%. Steven is making the minimum monthly payment of $200.
If Steven continues paying $200 per month toward that credit card balance, he’ll end up paying $7,175.57 in interest, and it will take more than seven years to pay it off.
But what if Steven does a cash-out refinance on his mortgage to pay off that $10,000 balance? To make the comparison simple, we’ll assume that Steven’s interest rate on the mortgage isn’t changing, so he’ll keep his existing rate of 4.47%. We’ll also assume he’s financing $5,000 of closing costs into the new loan.
|Using Cash-out Refi to lower bills|
|Existing mortgage||Cash-out refi|
|Original loan balance||$128,000||$115,000|
|Monthly Principal & Interest||$646||$581|
By doing a cash-out refinance, Steven was able to lower his monthly bills by $265 – that’s the $200 he was sending to his credit card each month plus the $65 reduction in his mortgage payment each month.
What to watch out for
Reducing your monthly outlay by $265 sounds great, but remember: Steven isn’t lowering his total debt load. He’s actually increasing it by the $5,000 in closing costs he refinanced into the new loan. Plus, he’s extended the length of time it will take to pay off that debt. If Steven bought the home 10 years ago, he exchanged a mortgage with 20 years remaining to a new 30-year mortgage. And the credit card balance that would have taken seven years to pay off has been extended for 30 years as well.
In fact, the additional $15,000 in mortgage debt will end up costing Steven $12,264.83 more in interest over the 30-year loan term, assuming the 4.47% interest rate.
Tax-savvy readers are likely saying, “But the interest on the mortgage is deductible, so you have to consider the tax benefits!” Not so fast.
Before Jan. 1, 2018, you would take potential tax benefits into the calculation. But recent tax reform legislation changed the rules for deducting mortgage interest.
The interest paid on a cash-out refinance is deductible to the extent that the proceeds were used to buy, build or substantially improve the home. In other words, if you do a cash-out refinance to remodel your home, the interest would be fully deductible. If the proceeds are used to consolidate debt, pay for your child’s education or any other purpose that isn’t buying, building or improving your home, then only interest on the portion of the loan that does pertain to the house is deductible.
This provision of the new tax law is set to expire in 2026. After that, if Congress doesn’t change the rules again, we’ll revert to the old rules where you can deduct interest on up to $100,000 of home equity debt, regardless of how the proceeds are used.
Alternatives to cash out refinancing
Before you pursue a cash-out refinance, consider and compare the other options:
Home equity line of credit
A home equity line of credit (HELOC) is a revolving loan that uses your home as collateral.
A HELOC may be a good option for consolidating other high-interest debt because the interest rate is typically lower than those charged on a credit card. However, most HELOCs are adjustable-rate loans, meaning if interest rates go up, your monthly payment and the cost of borrowing will go up.
Home equity loan
A home equity loan is similar to a HELOC in that you borrow against your home’s equity. However, unlike a HELOC, a home equity loan gives you a lump sum upfront, you repay it in fixed monthly installments, and home equity loans are generally fixed-rate loans.
If you can secure a personal loan with a lower interest rate, you may be able to pay the debt off faster than you would carrying the same balance on a credit card. The interest rate on a personal loan may be higher than that of a mortgage. However, with a shorter loan term, you may still pay less interest over the life of the loan than you would with a cash-out refinance.
In addition, personal loans are generally unsecured, so if you have trouble making payments, your home won’t be at risk.
Is cash-out refinancing right for me?
Smith said his company is seeing a lot of cash-out refinance transactions right now because of the housing market. “Demand is up coast to coast,” he said.
That increase in demand means more homeowners have seen the equity in their homes increase. In fact, according to CoreLogic’s Home Equity report for the fourth quarter of 2017, “U.S. homeowners with mortgages (roughly 63% of all properties) have seen their equity increase by a total of $908.4 billion since the fourth quarter of 2016, an increase of 12.2%, year over year.”
But is tapping into that equity to consolidate other debts a good idea?
Smith says the decision is not just about looking at how much money you’ll save per month. “It’s always better to talk to someone who can massage the data,” he said. “Conventional loans have risk-based interest rates, so you’ll get a better interest rate with 60% loan-to-value than you would at 80% loan-to-value. So using your equity to pay off debt may appear attractive, but it could actually increase your loan-to-value and your rate, and decrease the attractiveness. That’s a hard calculation for a consumer to do on their own.”
In certain cases, Smith said the benefits of using a cash-out refinance for debt consolidation are clear. He had a client who wanted to use a cash-out refinance to pay off $40,000 in credit card debt. “It was all revolving, high-interest debt. There was no question it was a good idea to eliminate it,” Smith said.
But when the debt you’re looking to consolidate includes car and student loans, the decision isn’t as obvious. Many car loans already have very low interest rates – averaging 5.11% for new car loans as of the fourth quarter of 2017. Student loans bring another layer of complexity to the decision, Smith said, because refinancing student loans into a mortgage may mean losing student loan benefits like deferral options and income-based repayment plans.
If you are interested in using a cash-out refinance to consolidate debts, make sure you have a plan to stay out of debt. Unfortunately, many homeowners who use them wind up back in the same situation a few years later, but this time without home equity to bail them out. That’s why the Center for Responsible Lending calls cash-out refinances “equity-draining transactions” and says the benefits of a cash-out refi are often only temporary, “as homeowners build up additional new credit card debt and start the refinance process again.”
Shopping around for the best deals
You might not think of refinancing your home as shopping, but it’s just as important to shop around for the best deal on a cash-out refinance as it is to look for the best deal when you buy a home, a car or a home appliance. Perhaps even more important, shopping around can help you save thousands of dollars over the life of the loan.
According to the Consumer Financial Protection Bureau, people who shop around may see substantial differences in the interest rates offered by multiple lenders. According to their research, “a borrower taking out a 30-year fixed rate conventional loan could get rates that vary by more than half a percent. Getting an interest rate of 4.0% instead of 4.5% translates into approximately $60 savings per month.”
To ensure you’re getting the best bargain, contact a mix of financial institutions, including credit unions, banks and direct lenders, or use an online tool like LendingTree to compare offers from multiple lenders.
Cash-out refinancing may make sense if you can lower your monthly payments, pay off high-interest debt and avoid incurring more debt after the refi. But it’s not always the best choice. If you are unable to make your monthly mortgage payments, you run the risk of losing your home.
Don’t simply consider the amount you’ll save by lowering your monthly payments. Also take a look at the effect a reduction in home equity and lengthening the term on your mortgage will have on your overall financial situation, now and for the next 30 years.