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Can I do cash out refinance that consolidates my debt?

Can I do a cash out refinancing that consolidates my current debt?

Michael Jensen, Mortgage and Finance Guru
, Mortgage and Finance Guru

Yes. Doing a cash out refinance to pay off or down your current debt is also called a debt consolidation refinance. Using the equity in your home to lower your monthly debt expense provides several benefits but there are multiple points to consider as well.

Advantages of a debt consolidation refinance include lowering your debt balance and monthly payments, reducing your mortgage rate and average cost of debt and potentially boosting your credit score over time. Additionally, paying off or down debt such as credit cards, car or student loans may help you qualify for a refinance because reducing your monthly debt expense improves your debt-to-income ratio. If you have a significant amount of debt the only way you may qualify for a refinance is if you payoff your debts.

Use ourDEBT CONSOLIDATION REFINANCE CALCULATORto determine how much money you can save

For example, if you have high recurring credit card payments, your debt-to-income ratio may exceed the maximum ratio permitted by the lender. But if you payoff your credit card balance when you refinance, you may be able to qualify for the refinance. Plus, if you can reduce your mortgage rate when you refinance, you realize an even greater financial benefit.

The example below demonstrates the financial advantages of a debt consolidation refinance for a borrower with a high credit card debt balance.

Before Debt Consolidation Refinance

Borrower Monthly Gross Income: $5,000

Current Monthly Mortgage Payment: $2,000

Current Monthly Credit Card Payment: $1,000

Debt-to-income Ratio: 60% ($3,000 (total debt) / $5,000 (income) = 60%)

The scenario above shows a borrower with a very high debt-to-income ratio who likely struggles to pay her or his bills. If the borrower is able to take cash out by refinancing and use that money to pay off her or his credit card debt completely, the debt-to-income ratio improves significantly.

In the scenario below, the applicant improves her or his financial position even though the monthly mortgage payment is higher because the borrower increases her or his loan amount to completely payoff the credit card debt.

After Debt Consolidation Refinance

Borrower Monthly Gross Income: $5,000

New Monthly Mortgage Payment: $2,250

New Monthly Credit Card Payment: $0

Debt-to-income Ratio: 45% ($2,250 (total debt) / $5,000 (income) = 45%)

One of the reasons why a debt consolidation refinance makes financial sense is because mortgage rates are usually lower than the interest rate on credit cards or other high-cost loans. For example, if you can payoff a credit card that charges an 18% interest rate with the proceeds from a mortgage with a rate of 5%, you significantly reduce your average interest rate and lower your combined monthly debt payments.

Review How a Debt Consolidation Refinance Works

If the loans you want to pay off with when you refinance have relatively low interest rates then a debt consolidation refinance may not save you much money. Additionally, if you are already scheduled to payoff loans within a relatively short period of time, a debt consolidation refinance offers minimal benefits because of the closing cost involved. Plus the mortgage rate on a debt consolidation refinance (or any cash out refinance) is higher than for a rate and term refinance when you receive no proceeds.

The table below outlines refinance rates and closing costs. We recommend that you contact multiple lenders to compare refinance quotes. There tends to be more variation in mortgage terms for a debt consolidation refinance which makes comparing multiple lenders even more important.

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Current Refinance Mortgage Rates as of May 23, 2019
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Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. Click for more information on rates and product details.

It is also important to make sure that you have enough equity in your home to both refinance your current mortgage and payoff the debt you want to consolidate. Lenders apply limits to the amount of your mortgage relative to the value of your home, called a loan-to-value (LTV) ratio.

Your home value must be high enough to support the loan amount you want including paying off your current mortgage balance in its entirety as well as any other loans you want to pay off or down. This is why it is important to understand the value of your home before you apply for a debt consolidation refinance.

The example below demonstrates the LTV ratio for a debt-to-consolidation refinance.  This example shows a 77% LTV ratio, which is below the limit used by most lenders and loan programs.  If the property value was lower or the mortgage amount was higher, the LTV ratio would be higher and potentially exceed the limit applied by the lender.  Please note that you are also required to pay closing costs, although you may be able to add them to your mortgage amount.

Property Value: $215,000

Current Mortgage Balance: $150,000

Credit Card Balance To Be Paid Off: $15,000

New Mortgage Amount: $165,000 ($150,000 + $15,000 = $165,000)

LTV Ratio = 77% ($165,000 (new mortgage) / $215,000 (property value = 77%)

Finally, it is important to highlight that many lenders require you to close all high balance credit card accounts and credit lines when your refinance closes. So you should not count on access to these accounts for credit in the future. While closing credit card accounts may limit your borrowing capacity, it may improve your credit score in the medium-to-long term which is another benefit of a debt consolidation refinance.

Sources

Fannie Mae Cash Out Refinance Guidelines: https://www.fanniemae.com/content/eligibility_information/eligibility-matrix.pdf

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About the author

Michael Jensen, Mortgage and Finance Guru

Michael is the co-founder of FREEandCLEAR. Michael possesses extensive knowledge about mortgages and finance and has been writing about mortgages for nearly a decade. His work has been featured in leading national and industry publications. More about Michael

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