Debt Consolidation Mortgage: Should You Get One?
A debt consolidation mortgage is worth considering to pay off maxed-out credit cards, high-payment car loans or a large debt amount compared to your paycheck. But before you decide on this loan type, it’s important to review the pros and cons of taking out a larger mortgage to clear out other debt.
What is a debt consolidation mortgage?
A debt consolidation mortgage is when you borrow more than you owe on your current mortgage and use the difference to pay off car loans, student loans, credit cards or other debt. Some programs allow you to borrow more of your home’s value than others.
How does a debt consolidation mortgage work?
A debt consolidation mortgage works like a cash-out refinance, and may even be called a debt consolidation refinance. You borrow more than you currently owe but use the cash toward other debt rather than putting it in your pocket. The credit accounts are paid off through the closing in most cases.
Your finances are vetted to confirm you can afford the higher mortgage payment. You’ll need a home appraisal to confirm you have enough equity — most loan programs only let you borrow up to 80% of your home’s value.
Below is an example of how much you’d save by taking out a $300,000 debt consolidation mortgage to pay off $50,000 worth of credit card and car loan debt. The loan also includes a $250,000 mortgage balance on a $500,000 home. The example assumes the current monthly payment for the car and credit cards is $750, and the current principal and interest mortgage payment is $1,350 per month.
|Current principal and interest mortgage payment||$1,342|
|Current debt payments||$750|
|Total current mortgage and debt payments||$2,092|
|New principal and interest mortgage payment||$1,476|
In this example, you save $616 per month with the debt consolidation mortgage. However, there are some other important financial considerations to keep in mind.
- Your mortgage payment is $134 per month higher. While that’s not a big increase in payment, it could become a challenge later if there are changes to your income.
- You’ve financed $50,000 worth of home equity. If you need to sell your home, you’ll net $50,000 less in profits.
- You can still use the credit cards you paid off. Most lenders don’t require you to close out the accounts paid off in a debt consolidation mortgage, which may make it tempting to use the credit cards again.
- You’ll pay more in non-tax-deductible interest over the life of the loan. A larger loan amount means you’ll pay more mortgage interest charges for the term of the loan. An added drawback: Current tax laws don’t allow you to deduct mortgage interest on the portion of your loan used to pay off non-mortgage debt.
Types of debt consolidation mortgages
Conventional cash-out refinance
If you have a credit score above 620 and a solid employment history, you can borrow up to 80% of your home’s value with a conventional cash-out refinance. The lender will need to verify your income and will require a home appraisal to confirm the value of your home. An added bonus: Because you can’t borrow more than 80% of your home’s value, you won’t pay monthly mortgage insurance (mortgage insurance protects lenders if you default on your loan).
FHA cash-out refinance
Borrowers with scores as low as 500 may qualify for a debt consolidation mortgage backed by the Federal Housing Administration (FHA). Like the conventional cash-out refinance, an FHA cash-out refinance caps you at borrowing 80% of your home’s value and requires proof of income and a home appraisal. One big drawback to FHA cash-out refinances: You have to pay two types of FHA mortgage insurance, including an upfront lump-sum premium of 1.75%. The second charge is an annual mortgage insurance premium that ranges between 0.45% and 1.05% and is divided by 12 and added to your monthly mortgage payment.
VA cash-out refinance
Eligible military borrowers may be able to borrow up to 90% of their home’s value with a loan guaranteed by the U.S. Department of Veterans Affairs (VA). Income verification and a home appraisal are required. Although there’s no mortgage insurance requirement, VA borrowers may have to pay a VA funding fee between 2.3% and 3.6% of the loan amount, depending on whether they’ve used their eligibility before.
Home equity loans
A home equity loan allows you to take out a second mortgage for the amount you’re eligible to borrow without paying off your current mortgage. You’ll receive the funds in a lump sum and typically have a fixed-rate payment and term that ranges between five and 15 years.
Home equity lines of credit
Home equity lines of credit (HELOCs) work like a credit card at first, allowing you to borrow money as needed and pay off the balance during a set time called a “draw period.” Payments are usually interest-only during the draw period but must be repaid on an installment schedule once the draw period ends.
If you’re 62 years or older with a lot of equity in your home (usually 50% or more), you may qualify for a home equity conversion mortgage (HECM), more commonly known as a reverse mortgage. Unlike a regular “forward” mortgage, you don’t make a monthly payment on a reverse mortgage, and the funds can be taken in a lump sum or credit line. However, unlike a regular mortgage, your loan balance grows each month, meaning you lose equity in your home over time.
Pros and cons of a debt consolidation mortgage
Here’s a side-by-side recap of the benefits and drawbacks of a debt consolidation mortgage to help you decide if it’s the right choice for your finances.
| You can pay off high-interest-rate credit cards
Your credit scores may improve with less revolving debt
You can apply the savings to your principal to pay down the higher balance faster
You’ll have more room in your budget to avoid using credit accounts in the future
You can use the savings to build up your emergency fund
| Your monthly mortgage payment will be higher
You’ll pay more in mortgage interest over the life of the loan
You won’t be able to deduct mortgage interest tied to your debt payoff
You could lose your home to foreclosure if you can’t afford the new mortgage payments
You’ll typically pay a higher interest rate
You’ll usually pay between 2% and 6% of your loan amount toward closing costs
Alternatives to debt consolidation mortgages
If you’re worried about consolidating debt and securing it through your home, there are other alternatives worth considering.
Personal loans. A personal loan allows you to take out a smaller amount, typically at a higher interest rate than debt consolidation mortgages. However, because the loan isn’t secured by your home, you don’t have to worry about losing your home if you can’t make the payments.
Debt management plans. Credit counseling organizations offer these types of programs to help people consolidate unsecured debt. There may be initial setup fees, and it could take longer to be approved because creditors must be contacted to negotiate what payments they’ll accept. A debt management plan may be a good option if you don’t qualify for a debt consolidation mortgage, due to low credit scores or collections on your credit report.