Refinancing a mortgage to pay off debt: the pros and cons
Declining mortgage interest rates in recent years have coincided with increasing levels of consumer debt for many Americans. Those trends have made more people consider mortgage refinancing as a way to reduce their consumer debt burden.
In the most typical scenario, a consumer obtains a new mortgage at an interest rate lower than his or her聽previous one. This reduction can lower monthly home payments and free up money to pay off credit cards and other high-interest debt. Consumers may also do a 鈥渃ash-out鈥� refinance, in which they take advantage of rising home values to borrow against their equity.
NerdWallet asked several financial advisors from its聽聽about key factors homeowners should keep in mind if considering these strategies.
What are the potential advantages of using refinancing as a debt-reduction strategy?
Robert Henderson, financial advisor, Mystic, Connecticut:聽The advantages to聽聽are numerous. The first advantage of refinancing is lower interest rates. Typical credit cards today can have interest rates anywhere from 10% to 20%, with 鈥減enalty rates鈥� being even higher for late-payers or those with poor credit. By consolidating your payments under your mortgage or home equity loan, it will likely drop your interest rate to anywhere from 3% to 6%.
Second, consumer debt is rarely tax-deductible. However, the interest on most mortgage payments can be used on聽your tax return as an itemized deduction and potentially save you some taxes.
Finally, you鈥檒l have more financial flexibility. With consumer debt, interest rates change, minimum payments change and terms change; it鈥檚 difficult to know from month to month what your payments will be. With a mortgage, you have one monthly payment, and in most cases you have the option to pay additional聽on the聽principal should you have extra money at any point.
Roslyn Lash, financial counselor, Winston-Salem, North Carolina:聽A simple 2% interest rate reduction can save thousands of dollars, which can open doors to聽opportunity, reduce debt and aid in financial freedom. For example, if a family purchased a聽home in 2010 with聽a 30-year fixed-rate mortgage for $100,000 at 5.5%, the mortgage (principal and interest) payment would be $568, excluding taxes and insurance. Since obtaining the mortgage, the majority of the monthly payments have been applied toward the interest. Six years later, in 2016, the balance is still $90,536.
If they were to refinance the loan at an interest rate of 3.5% for 20 years, the monthly payment would be $526. Refinancing the mortgage saves $42 per month and reduces the term of the loan by four years. The extra money saved per month can be applied toward reducing the family鈥檚 other obligations, such as other loans or credit card debt.
What are the potential disadvantages?
Russell Cron, financial readiness program manager, U.S. Army, Ansbach, Germany:聽Converting revolving (credit card) debt to mortgage debt, within reason, creates a better credit profile, but if deficit spending is part of your budget, it can spell disaster. This is a聽case where an individual immediately frees up revolving accounts, only to begin building up debt. While the credit profile improves at one point in time, failing to recognize bad cash-flow issues will only make matters worse, especially with a cash-out refinance 鈥� the debt will remain, but the equity in the home is now gone.
Lash:聽It鈥檚 easy to reward oneself after a refinance and use the monthly savings for a monthly shopping spree that could eventually lead to more debt. Therefore, it鈥檚 important to have a spending plan and to know exactly how much you are borrowing, the terms of the loan, and how you will spend any extra cash.
Henderson:聽If you are not financially responsible, it is very possible to聽and聽eliminate your consumer debts, and then turn around and charge your debts right back up again. If you decide to move or want to buy a different home, you may end up stuck with no equity 鈥� or even worse, be underwater on your mortgage (having more debt on your house than it is worth). This could be devastating if you are either forced to move or would very much like to move for a new job or some other important reason.
How can consumers best take advantage of this option?
Lash:聽When refinancing a loan, always compare rates from various sources. Check the rates with local lenders and credit unions, as well as with the bank that has your current mortgage. Your current bank may offer to reduce the fees that are typically associated with refinancing. This could save you hundreds or perhaps thousands of dollars.
Henderson:聽Do plenty of research on various mortgages to make sure you find one that makes sense for your situation. Research the terms and make sure there is no penalty for making additional principal payments, which can help聽you to pay down your mortgage early.
Cron:聽Capitalize on a refinance of this type by committing increased cash flow to savings, and resist the urge to increase spending. By the same token, seriously consider your budget and whether credit card spending is structurally part of your budget. If your cash flow is in deficit, no amount of refinancing will positively improve your situation. As my mom used to say, 鈥淵ou can鈥檛 get out of debt by borrowing money.鈥�
What else should consumers know?
Lash:聽There should be a definite benefit to refinancing. Look for one of three possible results: (1) a shorter term, (2) lower payment or (3) reduced cost over the life of the loan.
In addition, obtain the loan from a local lender that services its聽own loans, if possible. Let鈥檚 say, for example, that ABC Bank has several locations in your hometown, and you assume that you could visit a local branch and get any questions addressed. However, ABC Bank may have partnered with XYZ Servicing, which is located in another state. Therefore, you may be required to mail your payments to XYZ Servicing and it, not ABC Bank, is responsible for answering your questions. When you have a concern, this type of arrangement could be more complicated than walking into your local bank.
Cron:聽Learn from the mistakes of others 鈥� don鈥檛 cash out equity wildly in excess of your acquisition cost. That means that if your mortgage is at $150,000, and you originally purchased the home for $300,000, don鈥檛 refinance for $500,000 and take a big sum of cash out just because current valuations might allow it.
You鈥檒l also want to ensure that all the mortgage interest you pay will continue to be deductible, so read the Internal Revenue Service鈥檚聽聽to ensure you aren鈥檛 taking on nondeductible debt.
And shop for refinancing, hopefully from a position of strength. Because if one is聽聽to pay off other debt, it stands to reason that there is substantial consumer debt. Prime market rates might not be available in such a situation, and while the monthly payments might not increase, the overall effect might be to increase the interest paid by spreading consumer credit over a much longer period.
聽is the president of聽in Mystic, Connecticut
聽is a financial counselor at聽聽in Winston-Salem, North Carolina.
聽is a financial readiness program manager with the U.S. Army in Ansbach, Germany.
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