Cash-out refinancing: How it works

Use it wisely and cash-out refinancing can work great for consolidating debt.

Cash-out refinancing can be a great strategy to pay off debts and get you back on track financially.

Cash-out refinancing. Just what is it?
Cash-out refinancing involves taking out a new mortgage that has a larger principal than your current mortgage. The difference in principal is paid to you as cash, which you can use for almost any purpose, including debt consolidation.

This option only works when you have equity in your home. (Home equity is the part of the home that you actually own. For example, if your home is worth $250,000 and you still owe $200,000 on the mortgage, the difference is the equity available to you: $50,000 in this case. In general, that $50,000 is available for you to use, although the actual amount can depend on your lender.)

Debt consolidation
Say you have $50,000 in credit card debt and you are paying an 18 percent interest rate. You can get an interest rate at a fraction of that by using your home as collateral. With cash-out refinancing, you can increase your principal by $50,000. At closing, you get that $50,000 to use however you want. You can then pay off your credit card debts immediately. If you do that, the debt is then wrapped up into your mortgage, but that can be advantageous to you. Instead of paying an 18 percent interest rate that is not tax deductible, your new loan will have a much lower rate – probably somewhere around 6 percent -- and you are likely to get tax benefits since the debt is tied to your mortgage.

If you are considering cash-out refinancing, make sure you are aware of the potential pitfalls. Even though cash-out refinancing can be a great way to pay off debt, it can also be a foolish move if you do not curtail your spending. Cash-out refinancing does not help if you continue to run up credit card debt. If you acquire more debt, you only succeed in having a larger debt on your mortgage in addition to even more credit card debt.

Cash-out refinancing only makes sense if you couple it with financial restraint. Also keep in mind that the debt will now be tied to your mortgage, making it possible for you to lose your home if you fail to repay the debt.

Although cash-out refinancing should not be entered into lightly, it is a good option to get out of credit card debt and pay less interest if you make the move with caution.