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How a Debt Consolidation Refinance Works
In short, a debt consolidation refinance enables you to use the equity you have in your home to refinance higher cost debt. In theory, your mortgage rate should be lower than the interest rate you pay on your other debt such as credit cards, personal loans and car loans, so you may be able to reduce your average interest rate and total monthly debt expense by refinancing and rolling additional debt into your mortgage.
For example, if you have recurring debt, such as a credit card bill, it may make financial sense for you to take cash out of your home when you refinance and consolidate this high cost debt into your mortgage. While your mortgage balance increases, your non-mortgage debt decreases. By consolidating higher cost debt into your monthly mortgage payment and eliminating your credit card payment, you should be able to reduce your combined monthly debt expense.
For example, paying 4.500% on your mortgage is preferable to paying 18.0% on a credit card bill. Along the same lines, paying one $2,000 mortgage payment is better than a $1,900 mortgage payment plus an additional $200 credit card payment. While these figures are only examples, the same logic may also apply to student and car loans, depending on the interest rate rate and term for those loans.
- DEBT CONSOLIDATION REFINANCE CALCULATOR shows you how much money you can save by consolidating debt into your mortgage
One of the most important points to remember about a debt consolidation refinance is that you must have sufficient equity in your property to both refinance your existing mortgage and payoff the debt you want to consolidate. With a debt consolidation refinance, most lenders permit a maximum loan-to-value (LTV) ratio of 80%. LTV ratio is the ratio of the mortgage amount to the market value of your property. Your property must be worth enough to support your new mortgage amount while not exceeding the lender's LTV ratio limit.
If the fair market value of your home is $100,000, your current mortgage balance is $70,000 and you want to consolidate $10,000 of credit card debt when you refinance, your LTV ratio is 80% ($70,000 (current mortgage balance) + $10,000 (debt to be consolidated) / $100,000 (property value) = 80% LTV ratio). A lower property value or higher mortgage or debt amount may push your LTV ratio above 80%, which can make it challenging to qualify for the loan, depending on the lender's guidelines. We recommend that you determine the approximate market value for your property so you understand what mortgage size is achievable prior to discussing a debt consolidation refinance with lenders.
A debt consolidation refinance can be a valuable tool for you to use the equity in your home to reduce your monthly debt expense
While a debt consolidation refinance can help you lower your monthly debt payments and reduce your average interest rate, there are several points that borrowers should keep in mind. First, the mortgage rate for a debt consolidation refinance is usually .250% to .625% higher than the rate on a standard rate and term refinance when you do not take any cash out of your home. One of the main reasons to refinance your mortgage is to lower your interest rate so borrowers should make sure that a debt consolidation refinance provides financial benefits despite the potentially higher rate.
A key positive of a debt consolidation refinance is that it reduces your monthly debt payments, which may actually improve your ability to qualify for the refinance. Lenders use a debt-to-income ratio to determine what size mortgage you can afford. Your debt-to-income ratio is the maximum percentage of your monthly gross income that you are permitted to spend on total debt expenses including your mortgage and other loans such as credit cards. The lower your debt expenses, the higher the mortgage amount you qualify for. Because a debt consolidation refinance reduces your total monthly debt payments, it can help you qualify for the refinance. In fact, in some cases borrowers with significant debt cannot qualify for a standard refinance but they can qualify for a debt consolidation refinance because it improves their debt-to-income ratio.
The table below shows refinance mortgage rates and fees for leading lenders near you. We recommend that you contact multiple lenders to learn more about the loan terms for a debt consolidation refinance. Comparing multiple lenders and loan programs is the best way to save money when you refinance your mortgage.
Borrowers with multiple loans who are considering a debt consolidation refinance may need to decide what loan to pay off first. For example, if you have both a student loan and significant credit card debt, it may only be possible to pay-off one when you refinance. If possible, we usually recommend paying off the loan with the highest interest rate although the length of the loan is another factor. Longer loans may end up costing you more in interest expense over the long run even if they have a lower interest rate. Borrowers should consider the interest rate, monthly payment and total interest expense when determining what loans to pay off with a debt consolidation refinance.
It is also important to highlight that most lenders require that you close, not just pay-off, the debt accounts that you consolidate. This is because they want to make sure that you do not run up high loan balances immediately after you consolidate the debt. This means that you need to be able to manage your personal finances without access to those accounts after your mortgage closes. For example, if you pay off a credit card account when you refinance, you need to make sure that you have access to other sources of credit, if needed.
The example below demonstrates how refinancing enables you to use the equity in your house to eliminate expensive credit card bills, reduce your total monthly debt expense and lower your average interest rate. In this example the borrower has a $380,000 fixed rate mortgage and $20,000 in credit card debt. The mortgage has an interest rate of 5.000% and the credit card debt has an interest rate of 18.0%. The borrower is five years into the mortgage and has a loan balance of approximately $348,950.
The borrower refinances the mortgage at the original loan balance of $380,000 and uses the proceeds of $31,050 (the difference between the amount of the refinanced mortgage and the current mortgage balance) to pay-off the high interest credit card debt and pay refinancing closing costs. The borrower also keeps $9,176 in proceeds leftover from the refinancing although the borrower could have reduced the loan amount instead of taking out cash.
In this example, the new, refinanced mortgage has the same interest rate as the original mortgage -- 5.000%. By refinancing the original mortgage and completely eliminating the more expensive credit card debt, the borrower reduces his or her monthly debt expense by $322 even though he or she did not obtain a lower mortgage rate. Reducing your interest rate when you do a debt consolidation refinance increases your monthly savings even more.
Use our free mortgage quote feature to compare refinance proposals from leading lenders. Our quote feature is free, no-obligation and requires minimal personal information. Shopping multiple lenders enables you to find the best refinance terms.
Sources
“What do I need to know if I’m thinking about consolidating my credit card debt?” CFPB. Consumer Financial Protection Bureau, June 7 2017. Web.
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