Debt Consolidation Refinance 101
Looking to consolidate debt with a mortgage refinance? Learn more about debt consolidation refinance and requirements below
Many people take on debt for good reasons, from financing their educations to buying the cars that get them to work. But as you continue to make payments month after month, it can feel like there’s no finish line in sight. If you have substantial high interest debt, you’re probably looking for ways to pay it off more efficiently.
As a homeowner, you have more debt consolidation loan options than the typical consumer. For example, using home equity to pay off debt. A debt consolidation refinance can help you unlock this equity.
Below, we’ll explain what a debt consolidation refinance is, how it works, and its pros and cons. We’ll also discuss an alternative solution.
What is a Debt Consolidation Refinance?
Debt consolidation is the process of paying off multiple loans and credit cards with a single loan or credit card. The goal of debt consolidation is to pay off your debt at a lower interest rate or annual percentage rate than what you’re currently paying.
Refinancing is when you, as the borrower, will replace your existing mortgage with a new one. Many people pursue mortgage refinancing to get a lower interest rate, a more affordable monthly payment, or a longer or shorter loan term.
However, you can also refinance to get cash out from your equity and use it to consolidate your debt. Debt consolidation refinancing, also known as cash-out refinancing, helps you do just that.
How Does Debt Consolidation Refinance Work?
A debt consolidation refinance replaces your existing mortgage with a new one for a larger amount. You can use the extra money you receive from this loan to pay off your high-interest debt.
To see how much of a difference this can make, just take a look at the average interest rates for the following forms of financing:
- Mortgages – 2% to 3%
- Personal loans – 10% to 28%
- Credit cards – 15% to 18%
As you can see, mortgages offer much lower interest rates than personal loans or credit cards. By paying off your high-interest rate debt with a low-interest rate mortgage, you can save significant money in the long run. With less interest to pay, you can also get out of debt faster.
Why Do Debt Consolidation Refinances Offer Lower Interest Rates?
Debt consolidation refinances often come with low interest rates because they use your home as collateral. This means that your lender can foreclose on your home if you default on your mortgage payments.
Since lenders have a guaranteed way to recoup their money, financing your loan is less risky for them. As a result, lenders are often willing to charge a much lower interest rate on a secured loan.
Lenders don’t have this same level of security with unsecured debt. In turn, they must charge higher interest rates to account for the increased risk.
Debt Consolidation Refinance Requirements
To qualify for a debt consolidation mortgage refinance, you need:
- Adequate equity in your home – To qualify for a debt consolidation refinance, you usually need at least 20% equity in your home. Equity is the difference between the current market value of your house and your remaining mortgage balance.
You’ll also need to make sure you have enough equity to pay off your debt. When you have a lot of consumer debt to consolidate, you may need substantially more than 20% equity. The more equity you have, the more cash you can get out during the refinancing process.
- A good credit score – No matter what type of financing you apply for, it helps to have a good credit score. The credit score requirements for a debt consolidation refinance vary from lender to lender. However, most lenders require a credit score of at least 620.
A high credit score may result in better loan terms for you, such as a lower interest rate, more affordable monthly payments, and a larger loan amount.
- Low debt-to-income ratio – Most lenders require you to have a debt-to-income ratio of 43% or below to qualify for refinancing. If your debt-to-income ratio is currently higher than that, you may need to pay down some debt before applying for your debt consolidation refinance.
In addition to meeting these requirements, you’ll also need to verify your income, share your employment history, and have your home appraised.
How to Refinance Mortgage and Consolidate Debt
Once you’ve made sure that you’re eligible for a debt consolidation refinance, you can begin the application process.
Here are the steps you’ll need to take:
- Add up your debt balances
- Write down the interest rates you’re currently paying on each of them
- Shop around for a lender that offers cash-out refinances
- Apply for a cash-out refinance with a lender that quotes you a low interest rate
- Make sure that you’ll receive enough extra cash from the loan to pay off your debt
- Once you’re approved, use this cash to pay off your debt
- Start making monthly payments on your new, refinanced mortgage
As you can see, the process of debt consolidation refinancing is very similar to traditional mortgage refinancing.
Pros and Cons of Debt Consolidation Mortgage Refinance
Before you apply for a debt consolidation refinance, you should carefully consider the following pros and cons.
For some homeowners, refinancing their debt is a path to reduced stress. Here are some of the benefits of debt consolidation refinancing:
- Interest savings – As we’ve mentioned before, the major advantage of debt consolidation refinancing is being able to pay off high-interest-rate debt at a much lower interest rate.
- One monthly payment – If you have several credit accounts, managing them all can feel overwhelming. You have to juggle multiple due dates, minimum payment amounts, and interest rates. With so much to keep track of, it can be easy to forget a payment from time to time.
Fortunately, debt consolidation streamlines your debt. With just one debt payment to make each month, you can enjoy a whole new level of financial simplicity.
- Set end date – The hardest part about having credit card debt is never knowing when it will finally be paid off. If you only make the minimum payments each month, it could take decades. By rolling your consumer debt into your mortgage, you can have a clear end date in mind (whether that’s 15 or 30 years from now).
- Potential tax deductions – By taking out a debt consolidation refinance, you may be eligible for certain tax deductions.
While there are many advantages to consolidating debt with a mortgage refinance, it doesn’t come without its pitfalls.
Here are a few potential downsides to keep in mind.
- A mortgage loan term extension – Most mortgages have loan terms of 15 to 30 years. However, refinancing will reset the term of your loan. For example, you may only have 10 years left of your current mortgage. After refinancing, your loan term may extend up to 30 years.
- Higher mortgage payments – Debt consolidation refinancing increases your remaining mortgage balance. With a larger loan balance, you may have to make larger mortgage payments each month.
- Risk of foreclosure – While secured debt comes with a lower interest rate, it puts your collateral at risk. With debt consolidation refinancing, that collateral is your home—your most valuable asset and the roof over your head.
If there’s even a chance that you may not be able to afford your new mortgage payments, refinancing may not be the right move.
- A new interest rate (based on your current eligibility) – When you apply for refinancing, your lender will base your new interest rate and loan terms on your current credit score.
If your credit score has gone down since you took out your original mortgage, you may get stuck with a higher interest rate than you have now. In this scenario, you’ll want to do the math to find out if debt consolidation refinancing will actually save you money in the long run. If you are still interested but have poor credit, there are other options for how to consolidate debt with bad credit.
- Closing cost and other fees – Refinancing a mortgage involves many fees. For example, you may be charged a prepayment penalty for paying off your original mortgage early.
You will also be charged closing costs, which can range between 3% to 5% of your total loan amount. In turn, they can end up costing hundreds to thousands of dollars.
Since the goal of a debt consolidation refinance is to save money, you’ll want to make sure that these fees don’t counteract the interest savings you receive.
Pay Off Debt Without Adding to Your Debt
Debt consolidation refinancing is just one way to unlock cash from your equity. It’s not your only option. Another way you can pay off debt affordably is by working with a sale-leaseback solution.
Sale-leaseback programs for homeowners are designed to unlock your home equity without adding to your overall debt in the form of closing costs, points, and other hidden costs. You can do this by selling your home to us and becoming the renter. Meanwhile, you get to use your home equity towards paying off debt.
Debt Consolidation vs. Home Equity Loan
Looking to consolidate debt with a mortgage refinance? As a homeowner, you have more debt consolidation loan options than the typical consumer. If you are still unsure of alternative options for how to consolidate your debt, after reading this article, consult a financial advisor to discuss your options.
- NerdWallet. Current mortgage and refinance rates.
- ValuePenguin. Average Loan Interest Rates: Car, Home, Student, Small Business, and Personal Loans.
- WalletHub. What Is the Average Credit Card Interest Rate?
- Bankrate. How to get equity out of your house.
- The Mortgage Reports. How a cash-out refinance works: Rules, rates, and requirements.
- Rocket Mortgage. How To Claim Refinance Tax Deductions.