Refinance to pay off debt: Is it right for you?

A home isn’t just a place to live and make memories, it’s also an asset that can help you pay down debt and build wealth over time.

If your home’s value appreciates, you can leverage that increase to refinance and consolidate high-interest debt into one lower-interest mortgage payment. Refinancing can also offer savings compared to higher-interest debts like credit cards, and can provide funding for larger expenses like home repairs or college tuition.

But refinancing your home shouldn’t be done lightly – interest rates can fluctuate, insurance premiums may apply, and closing costs can add up. Let’s explore these factors so you can decide if refinancing to pay off debt is the right move for you.

Can you refinance to consolidate debt?

In certain situations, refinancing might seem like an appealing option to pay off obligations like credit card debt or student and personal loans.

But before diving into refinancing, take a moment to conduct a clear-eyed view of your finances. One key factor is home equity, or the difference between your mortgage balance and the home’s market value. The more equity you have, the more flexibility you’ll gain. If your home’s value hasn’t increased much yet, your options may be limited. But with enough time and careful planning, you can still position yourself for success.

One crucial point to remember as you consider refinancing to pay off debt: If your income changes and you can’t make the new mortgage payment, you could lose your home. Keep this in mind as you weigh your options.

If you make the decision to refinance your property, you have two options: a cash-out refinance, which turns your equity into cash, or a rate-and-term refinance, which replaces your mortgage with a new one. We’ll get to those later, but for now here are some important things to know about refinancing.

Sufficient home equity

As noted, you must have sufficient equity in your home in order to refinance – lenders generally require between 10% to 20% equity to qualify for a cash-out refinance. To determine equity, lenders will likely conduct an appraisal and apply a formula called loan-to-value ratio (LTV), the loan amount/appraised property value multiplied by 100.

For example, let’s say Alicia bought a house for $250,000, she has paid down $75,000 of the original loan, and the house is now worth $275,000. Using those numbers, Alicia’s LTV is roughly 64%, which means she has about 36% equity — well above the 20% requirement.

If a buyer has an LTV above 80%, that triggers the private mortgage insurance (PMI) requirement, meaning they must pay a monthly insurance premium until 20% equity is achieved. So if you don’t have 20% equity in your home, you’ll have to factor PMI into the overall financial impact.

Interest rates

One of the main benefits of refinancing is accessing lower mortgage interest rates compared to other types of debt. In other words, mortgage rates are often significantly lower than credit card annual percentage rates, which can make refinancing a more affordable borrowing option.

That said, keep in mind that refinancing brings closing costs, which can detract from the potential benefit of the lower interest rates.

Advantages of refinancing to pay off debt

There are plenty of benefits to using a home refinance as a way to pay off debt, including:

• Lower debt interest rates: Since mortgages usually have lower interest rates than credit cards (or other loans), you can reduce the interest of your debt overall.
• Streamlined payments: Reducing the number of your monthly bills can lower the risk of defaulting on any payment.
• Access to home equity: If the value of your home has gone up since you first purchased it, accessing your home equity can give you more flexibility.

Disadvantages of refinancing to pay off debt

While there are benefits to using a home refinance to pay off debt, there are also potential drawbacks that can have serious consequences. They include:

• Higher mortgage interest rates: If interest rates rise, a refinance could result in a higher interest rate than when you began.
• Closing costs and other fees: Refinancing your mortgage involves a fee of 3% – 6% of the loan amount.
• Increased monthly mortgage payments: Refinancing may result in larger monthly mortgage payments or a longer mortgage term.
• Risk of losing your home: Inability to pay higher mortgage payments could result in defaulting on payments, which could lead to foreclosure.

Should you refinance your mortgage to consolidate debt?

Deciding to refinance your mortgage is a move you shouldn’t take lightly. In addition to carrying several risks, there are certain financial criteria you must meet in order to move forward with refinancing.

For instance, banks often require a credit score of 620 or more and a debt-to-income ratio (DTI) below 50% to approve a refinancing. Also, factor in closing costs when evaluating whether refinancing makes financial sense.

As you’ve likely seen, there’s a lot to weigh when deciding whether refinancing is the right move. This chart puts several of the key factors in one place, making it easier to see the big picture and compare your options with confidence:

Refinance calculator

This may not come as a surprise, but evaluating refinance loan costs involves fairly complex calculations. Thankfully, the Rocket Mortgage^® refinance calculator can dramatically simplify this process.

The calculator compares a new loan to your current debts, helping determine whether lowering monthly payments or cashing out your equity is the better option. Check it out to see whether refinancing is the right option for you.

Three types of mortgage refinancing options

If you are going to pursue a refinance to leverage home equity and pay off debt (as opposed to adjusting your mortgage terms to improve monthly payments), remember that there you have three options here — each offering different financial benefits.

Cash-out refinance

With a cash-out refinance, you replace your current mortgage with a new, larger one and can receive the difference as cash. For example, if you owe $200,000 on a home valued at $300,000 and refinance into a $250,000 loan, you may receive about $50,000 at closing, minus any applicable costs. Funds can be used for things like debt consolidation.

This approach transfers your debt to the mortgage, essentially creating a higher mortgage and potentially taking advantage of lower mortgage interest rates. Bear in mind that stable income and a strong credit score — usually at least 620 or better — is required to qualify.

Rate-and-term refinance

This type of refinancing replaces the original mortgage with a new one featuring an updated rate and term — in other words, a lower monthly payment or a more manageable timeline.

Rate-and-term refinancing can help you lower monthly payments by extending your mortgage term, even if interest rates have risen. For instance, if you refinance $100,000 remaining on a 15-year mortgage into a new 30-year loan, you can likely reduce monthly mortgage costs, helping to free up cash for other priorities.

That said, while this approach can ease short-term pressure, it may increase the total amount you pay in interest over time. Remember that trade-off when you consider a rate-and-term refinance.

Government-backed mortgage refinance

Some borrowers are eligible for government-backed refinances like an FHA cash-out, which can open doors for people with lower credit scores. (Currently, a credit score of at least 580 is required to take advantage of this program.)

There are certain rules for this type of loan — you must have lived in your home for at least 12 months and paid your monthly mortgage on-time for one year, for instance. If you meet these requirements, this program could be a practical way to access funds and increase your financial flexibility.

Other effective ways to consolidate debt

If refinancing doesn’t make sense for you, here are some alternative ways to consolidate your debt:

• Personal loans: A personal loan can allow you to consolidate multiple debts into one loan with a lower interest rate than those of credit cards, though it may have a higher rate if the loan is unsecured. Also: be aware that this type of loan often includes origination fees, so factor that into your equation.
• Balance transfer cards: Some credit cards offer 0% introductory APR if you transfer your balance to them, but as always there’s fine print: a transfer fee will apply, and a high interest rate resumes after the promotional period.
• 401(k): Withdrawing funds from a 401(k) can provide debt relief, but this comes with the downside of taxes on the income, an early withdrawal penalty, and reduced retirement savings.

The bottom line: Refinancing can help, but weigh it carefully

Refinancing your mortgage to consolidate debt can be a good option if you can reduce your interest rate and monthly payments, but it shouldn’t be undertaken lightly. There are considerations to weigh, including interest, PMI, short-term versus long-term gains, and more.

That said, refinancing can provide you with a foothold that can help you make a dent in your debt. And as we’ve seen time and time again, paying down financial obligations can create its own momentum – and that momentum could help you get onto a path of true financial independence.

If refinancing sounds right for you, fill out an application with Rocket Mortgage today!

Refinancing may increase finance charges over the life of the loan.

To qualify for this offer, you must meet all standard FHA eligibility requirements. In addition, your total mortgage payment, including taxes and insurance, cannot exceed 38% of your income, your debt-to-income (DTI) ratio cannot exceed 45%, and you must have 12 months of verifiable housing history immediately prior to your application, no late payments 30 days or greater in the last 12-months, and no derogatory marks on your credit report. Not available on jumbo loans. Asset statements may be needed, no more than 1 day of non-sufficient fund fees are allowed in the most recent 2 months prior to application. Additional restrictions/conditions may apply.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.