Refinancing a mortgage to pay off debt: What to consider
Quick insights
- Refinancing your mortgage may help consolidate high-interest debts into a more manageable monthly budget.
- Before refinancing, compare the new mortgage terms with your existing debt to see if it’s truly beneficial for your financial situation.
- Explore different types of refinance options to see which product aligns with your debt payoff strategy.
When a first-time homebuyer closes on their dream home, they likely aren’t thinking about credit card balances or student loan debt. But life happens and it can feel overwhelming—figuring out how to pay unexpected bills, dealing with rising interest rates or simply juggling multiple payments.
Refinancing a mortgage may be an option if your goal is to consolidate other outstanding loans. Before jumping in, it’s important to understand what refinancing a mortgage involves and whether doing so for debt consolidation makes sense for your financial goals.
Can you refinance a mortgage to consolidate debt?
Yes. You can pursue debt consolidation through several products that factor in the terms of your existing mortgage:
- Home equity loan: You leverage equity to receive a lump sum of money and repay it according to the lender’s terms. The sum could pay off several loans, then you’re responsible for repaying the home equity loan.
- Home equity line of credit (HELOC): Using available equity, you open a line of credit you could use to pay bills or entire loan balances. There’s usually a time frame you can do this, called a draw period, then you have to repay what you charge to the HELOC.
- Cash-out-refinance: You refinance your entire mortgage loan to a larger amount and receive the difference in cash. This can be used to pay off and essentially consolidate other debts. Then, you’d have the new mortgage to repay.
Each option may help you streamline personal finances by consolidating debts. However, it’s key to evaluate whether refinancing terms help meet your goals for current debts and budget going forward.
Should you refinance your home to pay off debt?
This decision depends on your current financial situation and long-term goals. Refinancing may reduce immediate financial stress through lower payments; however, it could also extend your loan term or increase the total interest paid over time. Carefully weigh the short-term relief against the long-term costs before deciding to refinance your home.
Consider factors like your debt-to-income (DTI) ratio, closing costs and the impact on your loan-to-value (LTV) ratio because turning unsecured debt into mortgage debt carries long-term financial implications. Unsecured debt is money you owe (credit cards or personal loan) that isn’t backed by collateral like a house or vehicle.
Pros and cons of refinancing a mortgage to pay off debt
Before moving forward, it’s important to take into account the advantages and drawbacks of refinancing a mortgage for debt consolidation. There are several factors that should guide your decision, such as current rates, your DTI ratio, closing costs and long-term goals.
Pros
- Lower interest rates: Mortgage interest rates are usually lower than credit card or personal loan rates, which could help reduce overall interest costs.
- Simplified payments: Combining multiple debts into your mortgage creates one monthly payment that’s easier to manage.
- Potentially improved cash flow: Lower monthly obligations can free up money for savings or other financial priorities.
Cons
- Closing costs: Refinancing comes with fees and expenses that can add up quickly, reducing your immediate savings.
- Risk to your home: Converting unsecured debt into mortgage debt means it loses its status as personal debt, which may have implications if payments are missed.
- Repayment terms: Whichever loan product you choose, you still have to repay debt at certain rates over a certain amount of time. Any amount you might save also depends on the terms of the refinance—with certain information, you could estimate your refinance savings.
Cash-out refinancing
Cash-out refinancing allows you to borrow more than you currently owe on your mortgage and use the difference to pay off other debts. To qualify, you will need sufficient equity in your home (usually at least 20%). While this option can provide immediate access to cash, it also increases your LTV ratio, which could negatively impact your future borrowing power.
Example:
- Home value: $300,000
- Current mortgage balance: $200,000
- New refinance loan: $240,000
- $200,000 pays off your old mortgage
- $40,000 goes to you in cash
- New balance you owe: $240,000
You walk away with $40,000 cash for debt payoff, but your mortgage balance increases from $200,000 to $240,000. This matters because while you receive a large sum of cash to tackle your high-interest debt, you’re also increasing the amount you owe on your home loan (secured debt).
Rate-and-term refinancing
Rate-and-term refinancing focuses on adjusting the interest rate, loan term or both, without taking out extra cash. This approach may reduce monthly payments or lower total interest costs over time. It’s a great option for borrowers who want to improve loan terms while still consolidating debts into a single, manageable mortgage payment.
Example:
- Current mortgage balance: $200,000
- Current interest rate: 6.5%
- New refinance loan: $200,000 (same balance, no extra cash)
- New interest rate: 5%
- Monthly payment drops because of the lower rate
- New balance you owe: $200,000
You don’t receive cash in your hand, but you save money each month by paying a lower interest rate.
Alternative ways to consolidate debt
Refinancing isn’t the only path to debt consolidation. Depending on your financial situation, there are alternative options that may offer greater flexibility or less risk to your home.
- Personal loans: With fixed interest rates and terms, personal loans can simplify repayment without using your home as collateral. Always compare interest rates and terms to refinancing options to see which option is more cost-effective.
- Balance transfer credit cards: Many credit card issuers offer a low introductory interest rate for a limited time. Be cautious of transfer fees and the rate increase once the promotional period ends.
In summary
Refinancing to pay off debt can be a powerful financial tool, but it isn’t a one-size-fits-all solution. Before you make the decision to refinance, consider the pros and cons, explore various refinancing options like cash-out or rate-and-term refinance and compare them with alternatives, such as personal loans or balance transfers.
By weighing the options, pros and cons, you can choose the option that supports your financial situation and future plans.
