Short answer, it depends. If you’re a homeowner with equity in your home, refinancing your mortgage to pay off other debts, such as credit cards or auto loans, may seem like a solid plan for increasing cash flow. However, you could be trading lower monthly payments now for a greater long-term cost.
Here are the factors to consider if you’re looking to consolidate debt by refinancing your mortgage.
What It Means to Consolidate Debt
Consolidating debt is one way to improve cash flow by rolling several debts into one loan, usually obtained at a lower interest rate. For example, a family with an auto loan who is also paying down a balance on two credit cards, could refinance those debts into a single loan with a lower monthly payment.
When consumers consolidate debt by refinancing their mortgage, they are borrowing against the equity in their home. To understand this better, assume that the Smiths have $35,000 in equity in their primary residence. They owe $10,000 on an auto loan and $5,000 in credit card balances.
To pay off the outstanding debts, the Smiths could refinance their mortgage for more than they currently owe, rolling in the $15,000 from their auto loan and credit cards. When mortgage rates are low, this move would likely net the family a lower interest rate on all of their debts as well as a lower monthly payment, freeing up cash the family can use for other expenses.
Sounds like a winning proposition, right? But, let’s consider any downside.
Understanding the Risks of Consolidating Debt with a Refinanced Mortgage
While the Smiths have gained a few dollars in their monthly budget for the short term by consolidating debts through a refinanced mortgage, they’ve also made a decision that could impact family finances for years.
For one thing, the Smiths are borrowing away some of the equity they have gained in their home and likely extending the length of time it will take to pay off their mortgage. Additionally, if the Smiths borrowed more than 80 percent of their home’s value, they will need to purchase mortgage insurance at an additional monthly cost.
While the Smiths may add a few dollars to their monthly budget, they’ll be trading short-term debt for a long-term solution. That means that instead of paying interest on their car for the three years left on their auto loan, they will now pay interest on that amount for the length of their 15- or 30-year mortgage.
Look at It This Way.
If you are thinking about refinancing your mortgage to consolidate debt, it’s important to weigh the pros and cons.
Generally, if you plan to sell your home in four or five years, you’ll see a bigger benefit from refinancing, since you won’t be carrying the consolidated debt for the lifetime of a 15- to 30-year mortgage. In a low interest rate environment, consolidation over the short term could be a wise move, particularly if you’re carrying large amounts of other debt with high interest rates.
By refinancing credit card balances, you’re opting for a fixed payment over making payments on a revolving balance. This can be particularly advantageous when mortgage rates are low.
For example, if you’re carrying a balance on a credit card, you’re likely paying over 20 percent in interest on the money owed. You could refinance at a fraction of that, and if you plan to sell in four or five years, pay off the debt in less time than you would by making monthly minimum credit card payments at the higher rate of interest.
Keep this in mind: you lose the advantages associated with refinancing if you continue to accrue balances on your cards after the consolidation. Before deciding to refinance your mortgage in order to consolidate your debts, it’s important to commit yourself to a budget.
If you are thinking about refinancing or consolidating debt, your loan officer can help you evaluate your goals and calculate the short- and long-term impacts of your decision to discover the path that’s right for you.
The articles in this blog are for informational purposes only and not intended to provide specific advice or recommendations. When making decisions about your financial situation, consult a financial professional for advice. Articles are not regularly updated, and information may become outdated.