Can a cash-out refinance help reduce your debt load?
Struggling to pay off your credit cards or other debts? Are the high-interest rates attached to this debt causing it to soar each month? If you have enough equity in your home, and you can afford what might be a slightly larger mortgage payment each month, a cash-out refinance might be the answer.
In a cash-out refinance, you swap out your existing mortgage loan with a new version, just as with a traditional refinance. But instead of refinancing for what you currently owe on your mortgage, you refinance for a higher dollar amount. You then get those extra dollars in the form of a lump-sum payment. You can use this money for anything, including paying off your high-interest-rate credit card debt.
Here’s an example: Say you owe $200,000 on your existing mortgage. You can refinance for $225,000 instead, and then use that extra money to pay off or pay down your credit card debt. This is a good way to swap debt with high-interest rates with debt with lower mortgage rates. But there are plenty of factors to consider before you apply for a cash-out refinance.
Slashing the interest
Jared Weitz, founder and chief executive officer of Great Neck, New York-based United Capital Source, said that a cash-out refinance could be an effective way to reduce the interest you pay on your overall debt. That's because mortgage debt comes with lower interest rates than does credit card debt.
Consider these numbers: The Freddie Mac Primary Mortgage Market Survey showed that the average rate on a 30-year, fixed-rate loan stood at 4.1 percent as of May 9. Meanwhile, CreditCards.com reported that the average interest rate on a credit card was 17.73 percent as of May 15.
Swapping the lower interest rate of a mortgage for the sky-high rates associated with credit cards can dramatically lower the amount you spend to pay off your debt.
"With mortgage rates historically low, this is becoming a more common and valuable path," Weitz said.
The challenges of a cash-out refinance
The downside to a cash-out refinance is that you will likely increase your monthly mortgage payment, Weitz said, because you are refinancing for more than you owe. This means you will spend more if you hold your new mortgage until its final pay-off date. You’ll also need to make sure that you can afford this increase to your monthly debt obligation.
You might also extend the life of your mortgage when closing a cash-out refinance, Weitz said. Say you have 22 years left on your original 30-year, fixed-rate mortgage. If you close a cash-out refinance to a new 30-year, fixed-rate loan, you'll be increasing the term of your loan by eight years. To avoid this, you might consider refinancing an existing 30-year mortgage to a shorter-term version, such as a 15-year, fixed-rate loan.
This comes with its own challenge, of course, in the form of a higher monthly mortgage payment, due both to the shorter term and the extra cash you're taking out. Again, make sure you can afford the new payment before refinancing to a shorter-term loan.
You’ll also have to meet certain requirements to qualify for a cash-out refinance. Lenders typically require that you have at least 20 percent home equity before they’ll approve you for a cash-out refinance. If you don’t have this, a cash-out refinance might be outside your reach.
Having enough equity is more challenging for a cash-out refinance because, again, you are refinancing for more than what you owe on your mortgage. If you add $20,000 in cash onto your refinance request, you’ll have to include that amount when determining if you have enough equity.
Is a cash-out refinance right for you?
The key to calculating whether consolidating existing debt with a cash-out refinance makes sense? You need to determine if the savings you'll receive each month by reducing the interest rate on your overall debt will be enough to outweigh the probable increase in your monthly mortgage payment.
Medhi Kouchtaf, branch manager and senior loan officer with St. Louis-based Open Mortgage, said that cash-out refinances make the most financial sense when homeowners are struggling to pay off a significant amount of credit card debt at high interest rates.
He points to a client he worked with earlier this year. That client, after closing a cash-out refinance, is now saving $2,000 a month because he swapped his expensive credit card debt with lower-rate mortgage debt. His mortgage payment only jumped $200 a month, Kouchtaf said.
This client's experience isn't unusual, Kouchtaf said.
"The increase in the mortgage payment, if any, is typically a lot lower than the combined minimum payment on all the credit cards to be paid off," Kouchtaf said.
Other financial considerations
Kouchtaf does say there are drawbacks to a cash-out refinance. You will have to consider the closing costs, for instance. Refinancing a mortgage isn't free. If you have to pay $3,000 in closing fees, be sure to factor that cost into your savings calculations. You might still save enough each month in interest to make a cash-out refinance worthwhile, but those closing costs do mean that it will take you longer to start realizing those savings.
Depending on when you took out your original mortgage and how strong your credit is today, your new mortgage loan might also come with a higher interest rate. This new rate will almost certainly be lower than the rates attached to your credit card debt. But if you're uncomfortable with a higher mortgage interest rate, you might reconsider a cash-out refinance.
One benefit of a cash-out refinance has been tempered with the passage of the Tax Cuts and Jobs Act of 2017. Before this act passed, you could deduct on your income taxes the interest you paid on a cash-out refinance. Today, you can only write this off if you are refinancing to make physical improvements to your home. That won't be the case if you are using the dollars from a cash-out refinance to consolidate your credit card debt.
Cash-out refinancing on the rise
Matt Hackett, mortgage and finance expert at New York City-based mortgage lender Equity Now, said that cash-out refinancing has made a comeback after several years in which most homeowners ignored this option. Why? Hackett said that home values have steadily risen, giving homeowners more equity to tap. At the same time, mortgage interest rates remain low.
Hackett said, too, that lenders are loosening some of the credit standards for mortgages. He pointed to lenders willing to make loans to consumers with higher levels of debt and lower credit scores. He also said that some lenders are requiring fewer bank statements when verifying that borrowers can afford their new mortgage payments.
Hackett said that more than half of the refinance loans his company closes today include a cash-out portion.
Hackett said that the majority of homeowners he's worked with have been cautious with these loan products, not taking out more cash than they can afford to pay back.
"Would-be home refinancers are using caution and keeping the amount they take in cash well below the levels we often saw years ago," Hackett said.