Should I Refinance My Mortgage to Pay Off Debt?

If you’re dealing with significant debt, you may wonder, “Should I refinance my mortgage to pay off debt?” This is a common question for homeowners looking to consolidate high-interest debts, such as credit cards, medical bills, or student loans.

Refinancing your mortgage could be a strategic way to manage your finances better.

In this article, we’ll explore refinancing options, when they make sense, and alternative strategies for debt consolidation to help you make an informed decision.

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Understanding refinancing options

Refinancing means getting a new mortgage to replace your current one. This new mortgage might have better terms or be structured differently.

This can also be an effective way to access your home equity to pay off other debts.

Let’s look at different ways to refinance to achieve your financial goals.

Cash-out refinance

With a cash-out refinance, you can take out a bigger loan that pays off your current mortgage—the difference is given to you as cash.

This money can be used to pay off debts with higher interest rates.

For example, if your home is worth $250,000 and you owe $100,000, you could access up to 80% of its value—about $120,000.

Benefits of a cash-out refinance:

Lower interest rates: Mortgage rates are usually lower than credit card or personal loan rates.
Consolidated payments: Combining multiple debts into one mortgage payment simplifies your finances.
Potential tax advantages: Mortgage interest may be tax-deductible. (Consult a tax advisor for your specific situation.)

Rate-and-term refinance

A rate-and-term refinance involves replacing your current mortgage with a new one that has a different interest rate, loan term, or both.

While this option doesn’t provide cash for debt consolidation, it can lower your monthly payments by dropping your interest rate or extending the loan term. The savings each month can then be applied toward paying off other debts.

Benefits of a rate-and-term refinance:

Lower monthly payments: A reduction in your interest rate or longer term can lower your payments.
Interest savings: A lower interest rate can save you money over the life of the loan.
No new debt: You’re not increasing your overall debt load.

Assessing your financial situation

Before deciding to refinance your mortgage to pay off debt, it’s essential to evaluate your overall financial health.

Debt-to-income ratio (DTI)

The debt-to-income (DTI) ratio is the amount of monthly income that is used to pay off debts.

Lenders look at this ratio when determining eligibility for refinancing. A lower DTI ratio improves your chances of approval and could qualify you for better interest rates.

Credit score

Your credit score is your best ally for securing better interest rates when refinancing. Before applying, review your credit report for mistakes and work on boosting your score.

Interest rates on existing debts

Look at the interest rates on your current debts versus mortgage rates. If mortgage rates are lower, refinancing might offer savings.

Home equity

When you do a cash-out refinance, the equity in your home affects the amount of cash you can borrow.

After refinancing, lenders usually require you to keep at least 20% equity in your home.

Potential costs and risks

Before refinancing, consider the potential costs and risks involved:

Closing costs: Refinancing comes with closing costs—commonly between 2% to 5% of your loan amount.
Long-term costs: Extending your mortgage term could mean paying more interest over time.
Risk of foreclosure: Converting unsecured debt (like credit cards) into secured debt tied to your home increases the risk of losing your home if you can’t make payments.

Calculating the benefits and costs

Before proceeding with a refinance, carefully calculate the potential savings and expenses.

Step-by-step guide:

Determine your new mortgage rate: Get quotes from multiple lenders to find the best rate.
Calculate your new monthly payments: Use a mortgage calculator to estimate your new payments.
Add closing costs: Factor in all fees associated with refinancing.
Compare total interest costs: Calculate the total interest you’ll pay over the life of the new loan versus your current debts.
Assess the break-even point: Calculate the time needed for your savings to cover the refinancing costs.

Example

Current debts: $20,000 in credit card debt at 18% interest
New mortgage: Refinancing to a $120,000 mortgage at 4% interest
Closing costs: $3,000
Total interest savings: You would see a significant reduction compared to high-interest credit cards
Break-even point: If the closing costs are recouped within five years through monthly savings and you plan to stay in your home longer, refinancing could be a smart choice.

Alternative debt payoff strategies

If refinancing isn’t the best option for your situation, consider these other debt payoff strategies:

Debt avalanche method

Pay down high-interest debts first, and make minimum payments on your other balances.

Pros:

Saves money on interest.
Reduces the time needed to become debt-free.

Cons:

It may take longer to see individual debts disappear.

Debt snowball method

Pay off the smallest debts first to gain momentum, then focus on larger ones.

Pros:

Provides quick wins.
Simplifies the number of debts quickly.

Cons:

You might pay more in interest over time.

Balance transfer credit cards

Move any debt from high-interest credit cards to a card offering a lower or 0% introductory rate.

Pros:

Saves on interest during the promotional period.
Consolidates multiple debts into one payment.

Cons:

Balance transfer fees may apply.
Interest rates can increase after the promotional period.

Making an informed decision to refinance or wait

To make the best decision, consider this checklist:

Assess your financial situation: Evaluate your DTI ratio, credit score, and home equity.
Calculate costs and savings: Determine the total cost of refinancing versus potential savings.
Consider loan terms: Understand how changing the loan term will affect your financial goals.
Evaluate risks: Consider the risks, including the possibility of losing your home.
Explore alternatives: Look at other debt payoff strategies that might work better for your situation.