Q: My husband and I want to refinance our mortgage, but rates have gone up, and I'm hesitant. He says we can knock out credit card debt with a "cash out" refinance. I'm not sure I understand this. What are the benefits?
A: Most homeowners refinance to lower their mortgage rates and payment. A cash out refinance involves refinancing a mortgage and replacing it with a larger mortgage, trading home equity for additional cash. One way to use extra cash from cash out refinancing is wrapping high interest consumer debt like credit card balances into a refinance loan.
Because mortgage rates are typically lower (sometimes double-digits lower) than credit card rates, you can get a lower interest rate and a lower payment for that debt. If you owe $15,000 in credit card debt at 15 percent interest and make only the minimum payment, the Federal Reserve says:
You have entered a balance of $15,000 at 15.00%. We estimate that:
$300 - Estimated initial minimum payment
37 Years - Amount of time to pay off your balance, if you make no more charges and make only the minimum payment on time each month
$23,913 - Interest charges you will pay in that amount of time
This is an estimate based on the information you provided and assumptions made about your account. The actual time and cost to pay off your balance by only making the minimum payment will depend on the terms of your account and future account activity.
By adding that $15,000 to your mortgage, at a five percent rate, the payment falls to $81, but it takes 30 years to retire the debt and your interest drops to $13,990. If you continued to pay the $300 a month, though, your debt is done in just four years, nine months and drop your total interest charges to just $1,859!
Cash Out Refinance: Consider Hidden Costs
Keep in mind that in many cases, cash-out refinancing costs more than ordinary rate-and-term refinancing. Fannie Mae, for example, adds .75% in fees for a cash-out refinance at an 80 percent loan-to-value and a 700 FICO score. That surcharge is based on the entire loan amount, so if your total mortgage is $215,000 (your $200,000 current mortgage balance plus $15,000 for credit cards), you added fees are $1,612.50.
Refinancing for debt consolidation converts unsecured consumer debt, which could be discharged in a bankruptcy if necessary, to debt secured by your home. If your finances are shaky, this isn't a small matter.
In addition, about 80 percent of people who consolidate debt run their credit card balances up again. Remember, you STILL owe the money.
If you are confident that you can meet your refinance mortgage payment and not resurrect your credit card debt, a cash out refinance could simplify your bill paying chores, get you out of debt faster, and save you money.
The Federal Trade Commission (FTC) advises homeowners to understand that using their homes as collateral for debt consolidation may increase the risk of mortgage foreclosure, but if you have plenty of home equity and income, consolidating debt with a cash-out refinance can provide a solution for reducing financial "clutter.".