Debt is a part of life for most Americans, with a majority of baby boomers, Gen Xers, and millennials all reporting they owe money. Not only are most Americans indebted, but having lots of different types of debt is common, too -- including credit card debt, student loan debt, mortgage debt, medical debts, and personal loans.
All these debts aren't created equal, though. Mortgages tend to have much lower interest rates than most other kinds of debt. And, if you itemize your deductions, you can also deduct interest on up to $750,000 or $1 million in mortgage debt, depending on your tax filing status and when you bought your house.
When mortgage debt has a lower interest rate and is tax deductible, paying off other debt by refinancing your mortgage may seem like an attractive option. But can you do this. The question is whether or not it's a good idea?
Can you use a mortgage refinance to pay down debt?
It's possible, in some circumstances, to use a mortgage refinance loan to pay down debt. You can take a cash-out refinance loan to accomplish this. Essentially, the process involves applying for a new mortgage that's larger than the current total balance you owe. If you owe $200,000 on your home, you might take out a $250,000 mortgage. You could then use the extra $50,000 you borrowed to pay off other outstanding debts.
Your ability to take a cash-out refinance loan is dependent upon having enough equity in your home, as well as qualifying for a mortgage loan based on other financial factors such as your credit score and income. Most banks don't want you to have a mortgage exceeding 80% of your home's value, so you may be denied if you try to borrow more than this. Some banks allow you to borrow more -- up to 90% or even 97% of your home's value -- but you would need to pay private mortgage insurance (PMI) if your loan-to-value ratio exceeds 80%. PMI is insurance you pay for to protect the lender from loss in case the lender must foreclose.
If you're approved for the cash-out refinance loan, the lender would pay off your existing home loan and, when closing on the loan, you'd get the difference between what you owed and the new amount you borrowed.
Is it a good idea to use a mortgage refinance loan to pay down debt?
By refinancing your mortgage to pay down debt, you could significantly reduce the interest rate on some of your high-interest debt. If you have credit card debt at 20%, for example, you could reduce the interest rate way down if you can qualify for a mortgage at 4.25%.
However, by doing this, you're likely stretching out debt repayment over a much longer period of time, depending on which debts you refinance and how long it would otherwise have taken to pay them back. If you pay off a $10,000 personal loan at 10% interest over five years, you'd pay $2,748 in interest over the life of the loan. If you use a 30-year mortgage refinance loan and borrow an extra $10,000 to pay off your personal loan, you'd stretch out your repayments for 25 years longer. You'd pay $7,709.84 in interest over three decades on the $10,000 borrowed to repay your personal loan -- even with a mortgage interest rate of 4.25%. As you can see, the long timeline for mortgage payoff means it doesn't make a whole lot of sense to use a refinance loan to pay off debt you'd otherwise pay off much faster.
But if you have debt that's going to take you a long time to pay off anyway, it makes more sense to use a cash-out refinance loan to repay it. For example, I took out a 15-year cash-out refinance loan two years ago to pay off my remaining student loans. This made sense for me because I was on a 10-year repayment plan for student loans at a much higher interest rate and because I can deduct mortgage interest but don't qualify for a student-loan tax deduction.
However, even if you have a situation like this and paying off debt with a cash-out refinance loan makes financial sense, there are some downsides. You're putting your home at risk if you can't pay your new mortgage loan, as the lender could foreclose. And there could be substantial closing costs and fees to pay for the new mortgage loan. You need to be aware of the risks -- and costs -- before you move forward.
You can pay off debt with home equity in other ways -- but doing so isn't always a good idea
A mortgage refinance loan isn't the only way to tap into equity in your home to pay off debt. You could also take out a home equity loan and use the proceeds to pay off higher-interest debt. Home equity loans also usually have lower interest rates than credit cards, personal loans, and similar types of consumer debt. But they work differently than cash-out refinance loans.
When you take out a home equity loan, you don't get a big loan used to repay your current mortgage and keep the cash left over. Instead, you keep your current mortgage and take out a second smaller loan for the amount you need to pay off debt or accomplish some other goal. You can pick your repayment period, which might last anywhere from a few years to a few decades.
If you choose a shorter repayment timeline, or if you borrow only a small amount and pay it off early, you could save a lot of money this way. If you took out a $10,000 home equity loan to be repaid over five years at 5.25% interest and used it to pay off the $10,000 personal loan described above, the interest costs would come down to $1,391. This is a savings of $1,357.
However, there are some caveats here, too. First, you need equity in your home to qualify for a home equity loan, just as you need equity to qualify for a cash-out refinance loan. Second, home equity loan interest isn't tax deductible unless you've used the proceeds to improve, repair, or buy a home -- so you couldn't deduct the interest on a home equity loan taken out to pay off debt. And, just as with a cash-out refinance loan, there are closing costs and fees to pay, and your home is put at risk.
Finally, if you take out a home equity loan with a long repayment timeline, you again face the situation where total interest costs could be higher even if you're lowering your interest rate.
Look at the big picture before using home equity to pay down debt
Although it may seem attractive to take a cash-out refinance loan -- or otherwise tap into home equity -- to pay off high-interest debt, there are plenty of reasons to think twice about doing so. So, while you can usually do this, depending on your financial situation and the equity in your home, it's not necessarily a good idea.