Debt consolidation refinance: How it works, benefits and drawbacksIs refinancing your mortgage to consolidate high interest debt a good use of your home’s equity? If you are paying high interest debt each month with rates above 6%, the costs can rapidly become overwhelming. For some, the very best road out of this situation is a debt consolidation refinance. Debt consolidation involves paying off all your high interest debt using a lower interest loan to save money on interest payments. At today’s low home mortgage rates, a debt consolidation refinance or home equity loan can be an excellent method to save a considerable amount in interest. However it’s crucial to fully understand what will be accomplished when consolidating. There are far more advantages than disadvantages but understanding them will help you make the best decision. Your home’s equity can become your “Get Out of Debt Free Card” as long as you have a strategy to avoid history from repeating itself again.
How debt consolidation works
Debt consolidation is basically turning all of your debt bills into one debt bill using a lower interest loan. The goal is to not only pay less interest but to also turn your revolving debt(credit cards) into an installment loan with a specific payoff date.
High interest debt usually comes from unsecured loan sources like credit cards and personal loans. “Unsecured” implies the lending institution has no security to recover losses if you default on the financial obligation. (Unlike a home mortgage, which is “secured” by your house.)
Revolving debt, like credit cards, are financial traps that are designed to be mismanaged and keep you in debt forever. Gimmicks such as “0% balance transfers for 12 months” or “0% APR for the first 6 months” are the bait they dangle to get your debt.
These sound like sound financial strategies with 0% interest and all but 0% does not exist. There is typically a balance transfer fee of 3.5% or more and credit card companies know the stats. They know the likelihood of the consumer paying off their balance transfer or new purchase within the promotion period are slim to none. Numbers don’t lie and credit cards bank on the stats.
Installment loans have a specific payoff date and the interest you pay is fixed and determined at the start of the loan. However, you can prepay installment loans to reduce the effective rate of interest you pay and pay the debt off sooner.
It’s simple to get in over your head with numerous high interest payments going to different lending institutions every month.
Consolidating your debt by rolling your outstanding balances into a lower interest loan like a mortgage can really optimize your personal finances.
What is a debt consolidation refinance?
The goal of any debt consolidation strategy is to lower your regular monthly costs. Typically, a homeowners most affordable option is to use their home’s equity in the form of a mortgage.
At today’s low mortgage rates, you could potentially pay off credit card debts with an annual percentage rate of 18 to 25% using a mortgage with rates at or below 4%.
So, how does it work?
Homeowners wishing to consolidate debt often look into a cash-out refinance. You basically get a new mortgage that pays off your high interest debt as well as your previous mortgage. Most cash-out refinances are capped at 80% loan to value so you’ll need some equity for this to work.
For example, let’s say your home was worth $300,000, you have a mortgage balance of $190,000 and you have $45,000 in high interest credit card debt. You could get a new mortgage for $240,000, which is 80% of $300,000, and that could pay off your mortgage and high interest debt.
Requirements for the debt consolidation refinance vary depending on your equity position, credit score and loan type. A conventional cash-out refinance, the most common type, requires a minimum 620 credit score.
FHA also offers a cash-out refinancing program, which enables a lower FICO rating of 580. This program often has lower interest rates than the conventional loan.
However, the FHA Loan is a little more costly as you’ll pay both an upfront and regular monthly mortgage insurance premium. This will increase the overall cost of your brand-new loan and may reduce your savings margin.
For qualified veterans and service members, another alternative is to consolidate debt via the VA cash– out refinance. Unlike other refi programs, the VA cash-out loan lets you refinance 100% of your home’s value. This means Veterans may qualify even if they don’t have sufficient equity for a conventional or FHA debt consolidation loan.
Advantages and disadvantages of a debt consolidation home loan
A debt consolidation can be a wise method to save on interest and pay your debt off faster. But if financial tragedy strikes or you get loose in your spending after the refinance, the potential risks become higher.
The obvious advantage of a debt consolidation refinance is that you’ll save money by lowering the interest rate on your debt. This could save you a huge amount of cash in the long run.
Think about it, let’s say you had 4 or 5 credit cards with interest rates in the 18 to 25% range. These cards are at or near their credit limit and you are making minimum regular monthly payments. Not only will you most likely never ever pay these off. You’ll also pay a great deal in interest.
Now envision that you consolidated all of these debts into one loan with an interest rate below 4%. You would save a ton both monthly and in interest. In fact, the cost savings you’ll gain on paying less interest might be used toward pre-paying the loan principal.
If you save $400 per month by consolidating and then apply the $400 to every monthly payment on the new mortgage, you would likely shave 10 years off the new mortgage.
Another advantage to consolidating high interest credit card debt is that it will improve your credit score. Paying off your credit card card balances will dramatically improve your “credit utilization ratio.”
Approximately 30% of your credit score is based on “credit utilization ratio” so you could see a giant leap in credit score once the balances are paid off. In basic, the lower your usage ratio, the better your FICO credit rating.
Settling high interest credit cards with a low rate mortgage refinance might sound like a no brainer. However there are some really genuine risks to look out for.
Debt consolidation methods have a high failure rate. And credit professionals say that a high percentage of those who utilize home equity to pay off credit cards will then run their cards up once again. If this happens, the homeowner could end up in even worse shape than when they began.
Keep in mind, unlike unsecured credit cards or personal loans, a mortgage is secured against your home. This means you’re pledging your equity as security for the loan you obtain.
In a worst case circumstance, a homeowner might refinance their debts then accumulate new debts so high they can no longer afford to pay for regular monthly mortgage payments. They might face foreclosure and eventually lose their home.
It’s likewise essential to bear in mind that a home loan refinance includes resetting your loan term. If you were 10 years into a 30 year home loan at the time of refinance, your remaining term would reset from 20 to 30 years.
This indicates you’ll be paying interest for a prolonged amount of time. So despite short term cost savings on your high interest unsecured debt, you might wind up paying more when all is said and done.
In general, a debt consolidation refinance can be a smart way to pay down debts at a much lower rate of interest. However it requires a high level of discipline in making payments to avoid unfavorable repercussions.
Remember, you still owe the money. With any type of debt consolidation loan, the borrower must exercise care and be exceptionally disciplined with payment. That’s especially true with a mortgage or home equity backed loan, which could put your house at danger if you’re not able to make payments.
Borrowers sometimes enter into trouble because when debt is combined, their prior credit lines are usually maximized. It’s possible they will charge those credit lines to the max again and repeat the problem.
Keep in mind, debt consolidation does not indicate your financial obligations have been “eliminated.” They’re simply restructured to be more workable. The genuine objective is to be debt free as fast as possible; a debt consolidation refinance is just a method to that end.
Your next steps to getting out of debt and saving thousands.
Debt consolidation refinance can be a genuine path to financial freedom. However you need to be knowledgeable about the potential problems ahead in order to avoid them and get out of debt successfully. Contact Michigan Mortgage Solutions at 248-674-6450 for a FREE Financial Optimization strategy call.