Should You Refinance Your Mortgage to Pay Off Debt?

The average American household has $104,215 in personal debt, according to Experian data — and if you’re in a similar situation, you might be looking for a way to consolidate your balances and save on interest.

One option you can utilize if you’re a homeowner is a cash-out refinance, but there are benefits and drawbacks to consider before taking this approach.

How refinancing your mortgage can help you pay off debt

When you refinance a mortgage to pay off debt, one of the main benefits is you’ll pay less in interest costs. Mortgage rates are much lower than rates on other consumer products like credit cards, personal loans, and private student loans.

How you use a refinance to pay down your debt depends on whether you do a rate-and-term refinance or a cash-out refinance.

Rate-and-term refinance

A rate-and-term refinance allows you to take out a mortgage with a new loan term, a new interest rate, or both. The old loan is paid off, and you make payments on the new mortgage over time.

Ideally, you save money with a lower rate — and with those savings, you pay down your higher-interest debt.

For example: Let’s say you want to refinance your home to pay off credit card debt. You have a $200,000 mortgage balance with a 5% APR and a $1,690 monthly payment.

Refinancing into a new 30-year loan with a 3% rate can lower your monthly payment to $1,240 a month. With the $450 monthly savings, you could pay off a $5,000 credit card balance within a year, assuming an 18% APR on the card.

Cash-out refinance

When you do a cash-out refinance, you take out a new mortgage loan for more than what you owe, pay off the original mortgage, and pocket the difference in cash. You can then use that cash to pay down other debts.

To qualify for a cash-out refinance, you’ll need to have enough home equity and meet credit requirements.

For example: Let’s say you have that same $200,000 mortgage balance, but this time you have $10,000 in credit card debt as well. With a cash-out refinance, you’ll take out a new mortgage for $210,000 to cover both balances.

When the lender gives you the extra $10,000 in cash, you’ll use that to pay off the credit card balance.

See: Reasons for a Cash-Out Refinance: How to Use Your Home Equity

How to qualify for a cash-out refinance

The qualification requirements on a cash-out refinance differ from those on other refinances because you’re borrowing from your home equity.

To qualify for a cash-out refinance, lenders usually check that you have:

• A credit score of 620 or higher
• A debt-to-income ratio of no more than 45%
• Enough equity in your home that you can keep 20% equity after the refinance

Find out: What Documents Do You Need to Refinance Your Mortgage? A Checklist

Pros and cons of refinancing to pay off debt

The most immediate benefit you get from refinancing is that you save money. But this move can also impact your credit scores, and you’ll need to account for the costs involved. Consider these pros and cons before refinancing your home to pay off debt.

Pros

• You could save money every month. When using a rate-and-term refinance to consolidate debt, you get a loan with a lower interest rate. The benefits are twofold: Not only do you save money on interest, but you also enjoy a lower mortgage payment.
• You could pay off the debt more quickly. Your other option is using a cash-out refinance, which increases your mortgage payments — but this allows you to quickly pay down high-interest balances.
• You might get a tax benefit. The interest you pay on a mortgage is tax deductible if you qualify and you itemize your deductions. The balances you’re paying off with a refinance — such as credit card debt — are generally not tax-advantaged.

Cons

• You use your home as collateral. When using a cash-out refinance to consolidate the credit card debt, you’re essentially converting unsecured debt to secured debt. Your mortgage payments will increase, and if you can’t keep up with them, the bank could foreclose on your property.
• Closing costs could eat into your savings. Do the math to see if the costs of refinancing are worth it. Closing costs, which are fees you pay the lender to process the loan, cost around $5,000 on average. You can typically choose to pay those costs upfront or roll them into the new mortgage.
• The loan could impact your credit scores. When you apply for a refinance, the lender performs a hard inquiry on your credit reports. This could temporarily lower your credit scores. The refinance also resets the average age of your credit history, which could also impact your credit.

Learn More: How to Get the Best Mortgage Refinance Rates

Should you refinance to pay off debt?

Refinancing a home loan to consolidate debt could make sense if you qualify for new loan terms that help you save money.

Here are some questions to ask yourself before applying:

• Which type of refinance is best for me?
• Do I qualify for the refinance?
• If I do a cash-out refinance, can I afford the new mortgage payment?
• If I do a rate-and-term refinance, how much money do I save each month?
• If I change the mortgage loan term, will I end up paying more interest overall? Am I OK with that?

Learn more:

• Should You Refinance Your Mortgage to Pay Off Student Loans?
• Should You Get a Cash-Out Refinance to Invest?
• Mortgage Refinancing Calculator

Other ways to pay off debt

There are other ways to pay down debt without using your home as collateral. Start by figuring out how much you earn, how much of your income goes toward essential expenses, and how much is left, which you can put toward your debt each month.

Then, look into the following strategies for paying off debt. The best method comes down to your financial situation or preference.

Get a balance transfer credit card

A balance transfer allows you to move multiple debt balances to one credit card. Some come with a 0% introductory APR for an extended period of time, usually 12 to 21 months. If you can pay down the balance within that time frame, then you can save money.

The interest rate usually increases after that introductory period, so if you have a balance remaining, your debt could get expensive.

This option also might not help much if you can’t consolidate all of your debt. You might receive different loan terms — and issuers might limit the amount you can transfer to the account.

Get a debt consolidation loan

A debt consolidation loan is usually an unsecured personal loan that you pay back in installments over time, typically three to five years. This can be a good option if you qualify for one with good terms and you prefer a predictable payment schedule.

Use the debt snowball method

It might not be worth consolidating your debts if you have small balances that you can pay off within a year, or you don’t qualify for a personal loan or credit card.

With the debt snowball method, you make the minimum payments on all of your debts every month, but you put any extra money toward your smallest debt first. Then, move in order from the next-smallest balance to the largest. You should gain momentum like a snowball rolling down a hill.

Use the debt avalanche method

Also a good option for people who don’t qualify for a loan or credit card, the debt avalanche method helps you save money on interest.

You make the minimum payments on all of your debts, but put your extra income toward the balance with the highest interest rate. Once it’s paid off, keep moving to the balance with the next-highest interest rate until all of your debts are gone.

Consider a debt relief program

You might need professional financial help if you can’t pay your monthly debt bills, can’t pay down your unsecured debt within a few years, or your debt equals more than half of your income.

Contact a nonprofit credit counseling organization. A certified financial counselor can go through your finances with you and help you come up with a plan of attack.