Refinancing your home to pay off other forms of debt can be a great way to lower your interest rate. However, it you don't exercise some caution, it can actually cost you more in the long run and could even result in losing your home.
If you decide to refinance your home to pay off debt, you should understand how best to make it work for you, and also understand what pitfalls you need to avoid.
Ways You Can Refinance Your Home to Pay Off Debt
The numbers in favor of using a mortgage to pay off other forms of debt, especially credit card debt, are compelling. According to the Federal Reserve, the average credit card balance is charged 13.51 percent. The average personal loan is at an interest rate of just over 10 percent, and car loan rates are above 4 percent. Compare those rates with 3 to 4 percent for a mortgage, and the potential for saving money is obvious.
Converting these other forms of debt to a mortgage can also stretch out repayment over a longer period of time. There is a downside to this, but if you are overwhelmed by monthly payments, this can help make them more affordable. And, if nothing else, consolidating multiple debts into one can make your financial obligations easier to manage.
If you have sufficient equity in your home, here are a couple ways you can refinance your home to pay off debt:
- Home equity loan. Perhaps the simplest approach is to get a home equity loan in an amount roughly equal to the debts you want to pay off. This makes for a fairly simple cost comparison, and lets you pick a time frame for retiring those other debts that does not have to be tied to the time frame for paying off your entire home. This is also the best option if mortgage rates on your existing mortgage are lower than current rates.
- Cash-out refinancing. If mortgage rates have fallen below those of your existing mortgage, you can kill two birds with one stone by doing a cash-out refinancing. This both refinances your existing mortgage and taps into the equity in your home for money to pay off other debts. If interest rate conditions are in your favor, this allows you to save on both your mortgage and those other debts.
Once you have decided on the type of mortgage that best fits your situation, be sure to shop around and compare interest rates from different mortgage lenders. After all, since you will be taking on a multi-year loan, getting the best savings you possibly can will really add up over time.
What Can Go Wrong?
With so much in favor of refinancing a home to pay off debts, what could go wrong? Here are three areas of concern:
- Stretching short-term debt into long-term debt. Mortgages are designed primarily to help you pay off a house over many years, while things like credit cards are designed for more immediate repayment of short-term purchases. If you start using long-term debt to finance short-term purchases, you will find it hard to ever get out of debt. Also, even at the lower interest rate of a mortgage, stretching your debts over longer periods can cost you more in the long run because you are paying interest for years more.
- Enabling bad habits. If you use a mortgage to pay off maxed-out credit cards, make sure you are not simply enabling bad habits. If you start building your credit card balances right back up again, you will find yourself back where you started only without as much equity to pay off your other debts this time.
- Putting your home in jeopardy. Failure to pay other forms of debt can have serious consequences, such as ruining your credit rating or getting a car repossessed. However, none of those consequences is quite as serious as putting your home at risk, and that's what you are putting on the line when you take on extra mortgage debt.
The above should not necessarily deter you from refinancing your home to pay off debt, but they should make you think it through first. The trick is to not simply be satisfied with the short-term relief this brings, but instead use it as part of a long-term debt reduction strategy.
Finally, if you want the option of refinancing your home to pay off debt, you should pursue it before your debt problem starts to damage your credit rating. Once that happens, your options for refinancing might become considerably more limited, and whatever options are available are likely to cost you more.