Should You Refinance To Pay Off Debt? A Look At The Pros And Cons of Refinancing
Jerry Brown6-Minute Read
May 07, 2022
Are you struggling to pay off debt? You’re not alone. The total debt for American households reached a record high of $15.58 trillion in 2021, according to Federal Reserve data. If you’re a homeowner, a potential solution is to refinance your mortgage to pay off non-house debt.
Since mortgage debt usually has a lower interest rate than other types of debt, refinancing your home or tapping your home’s equity via other home loan options could help you pay off your debt faster and save money. But before you refinance your home to pay off debt, you should weigh the pros and cons. Here’s what you need to know.
Can You Refinance To Pay Off Debt
If you’ve built up enough equity in your home, you may have some options when it comes to paying off personal loans, credit cards, student loans and other types of debt. For example, you can tap into your home’s equity with a cash-out refinance. You can then use the funds to pay off higher-interest debt, effectively shifting your debt burden to a lower-interest option in your mortgage.
Debt consolidation allows you to combine multiple financial obligations into a single debt. A major benefit of consolidating your debt with a cash-out refinance is that it can help you convert higher-interest debt into lower-interest debt.
Options For Refinancing
There are several loan options available for refinancing your home or tapping your home’s equity to pay off debt faster.
With a cash-out refinance, you replace your existing home loan with a new, larger one. After you close on the new loan, you receive the difference between the two loans in cash, minus closing costs. You can then use the cash to pay off higher-interest rate debts, like credit cards, personal loans and medical bills.
When you do this, those debts become mortgage debt. This means you’ll only have to manage one monthly payment at a lower interest rate.
Rate And Term Refinances
A rate and term refinance, also known as a standard refinance, involves paying off your current mortgage and replacing it with a new one. The new home loan typically comes with a new term, new interest rate, or both.
If you qualify for a lower interest rate, you can lower your monthly mortgage payments. This can free up cash in your budget to put toward repaying higher-interest debts.
You can apply for a streamline refinance if you have a VA loan or FHA loan – it typically requires less documentation than traditional refinance options.
Home Equity Line Of Credit
A home equity line of credit (HELOC) allows you to borrow against the equity in your home. You can borrow up to the amount of your credit limit as needed during a draw period that usually lasts 10 years. Once this period ends, you can no longer withdraw money, and you have to repay any outstanding balance over a certain period of time.
You can use the funds for any purpose, including consolidating higher-interest debt.
Is Refinancing To Pay Off Debt A Good Idea?
The answer depends on your unique financial circumstances. It could make sense if you can qualify for a lower interest rate and save enough money to recoup the closing costs. But it may not be the best option if you think you’ll continue to rack up debt after refinancing.
Let’s take a look at some of the advantages and disadvantages of refinancing to pay off debt.
Pros Of Refinancing To Pay Off Debt
Some of the advantages of refinancing your home to pay off debt include:
- Saving money: If you secure a loan with a lower interest rate than your existing mortgage, it could save you thousands of dollars over the life of the loan. As a result, you may have some extra cash in your pockets to put toward repaying debt. You could also save money by consolidating debt with a cash-out refinance.
- Paying off debt faster: An additional perk of putting extra money toward your debt or consolidating it is that you can pay it off faster. This can free up money to put toward other financial goals, like retirement or a dream vacation.
- Tax benefits: If you itemize when you file your taxes, you may be able to deduct the interest you’ve paid on your mortgage. But the interest you’ve paid on other debts, like credit cards and personal loans, usually isn’t deductible. It’s best to consult a tax professional to discuss your unique situation.
- Simplifying payments: If you’re repaying several debts, keeping up with multiple due dates can be challenging. But if you tap your home’s equity to consolidate your debt, you’ll have fewer due dates to keep up with. And this can make it easier to manage your bills and help you avoid late fees.
Cons Of Refinancing To Pay Off Debt
But there are disadvantages as well, such as:
- Using your home as collateral: Credit card debt and personal loan debt are usually unsecured, meaning a financial institution can’t take an asset, like your home or car, if you fail to repay what you owe, at least without a court’s permission. But if you tap your home’s equity to pay off those debts, you convert them to secured debt. This means that if you fail to repay the loan, a lender can foreclose on your home.
- Impact of closing cost and fees: Refinancing isn’t free – you have to pay closing fees. Though closing costs vary, you’ll likely pay 2% – 5% of the loan amount, according to Freddie Mac. This means if you take out a $100,000 mortgage, you’ll pay $2,000 – $5,000 to refinance your home. You’ll have to factor these costs in when deciding whether refinancing to pay off debt is right for you.
- Impact on credit scores: When you apply to refinance, a lender performs a hard credit check to assess your creditworthiness. This can temporarily drop your credit score. What’s more, taking out a new mortgage lowers the average age of your credit accounts, which could also lower your score.
- Doesn’t fix bad spending habits: Before you refinance your home to pay off debt, review your finances to see why you got into debt in the first place. If you got into debt because of bad spending habits, a refinance won’t help you stay out of debt in the future.
Other Strategies To Help Pay Off Debt
If you want to pay down debt fast but don’t think refinancing your home or tapping your home’s equity is the right move, consider these debt repayment strategies
- Debt snowball: With the debt snowball strategy, you focus on putting any extra money toward paying off your smallest debt first while making minimum payments on your other debts. And once that debt is paid off, you move on to the next smallest balance. Seeing your smaller debt balances paid off may encourage you to stick to the plan.
- Debt avalanche: The debt avalanche strategy involves putting any extra money toward your highest-interest rate debt first while making minimum payments on your other debts. After it’s paid off, you focus on paying the debt that has the next-highest interest rate. An advantage of this strategy is that it allows you to save more interest than the debt snowball method.
- Debt consolidation: There are other ways to consolidate debt without tapping your home’s equity. For example, if you have good to excellent credit, you may qualify for a 0% interest balance transfer credit card. These cards come with a 0% interest-free period that often lasts 6 – 18 months. Transferring a higher-interest balance from another credit card could help you save money. But once the interest-free period expires, you’ll have to pay interest on any remaining balance. Also note that you may have to pay a fee to transfer your balance.
- Debt relief program: If you need help, consider reaching out to a non-profit organization that offers credit counseling. A counselor can create a personalized debt management plan for you.
- Increase income: Although it’s easier said than done, earning more money and putting it toward your debt is a surefire way to pay it off faster. If you have time, you could pick up a part-time job or side hustle.
- Personal loan: Struggling to pay off high-interest credit cards? Taking out a personal loan to consolidate your credit card debt could be a good idea. Personal loans typically have lower interest rates than credit cards. But keep in mind rates vary by lender, and you’ll need a good or excellent credit score to qualify for the lowest interest rates.
The Bottom Line: Should You Refinance To Pay Off Debts?
Refinancing your home to pay off higher-interest debt could help you get out of debt quicker, but it has potential drawbacks. For instance, a major con is that you could lose your home if you tap your home’s equity to consolidate high-interest debt and fail to repay the loan.
Whether you should refinance your mortgage to pay off debt depends on your unique financial situation. If you’re considering taking this action, consult a financial advisor to help you determine if it’s the right move.
If you don’t want to put your home up as collateral or you don’t qualify for refinancing, explore other debt repayment strategies, like taking out a personal loan to consolidate debt or using the debt snowball or debt avalanche repayment strategies.
You can read more helpful tips on how to tackle debt by checking out our Rocket HQSM Personal Finances page.
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