When you have earned enough equity in your home, you have the opportunity to do a cash-out refinance. Technically this cash can be used for anything you care to buy, but by using it to pay off debt--credit cards, auto loans, student loans, medical bills, etc.--you can effectively replace those separate debts with your single mortgage loan. Instead of many bills to pay, you just have one. This is what is meant by debt consolidation through refinancing.
Turning Equity Into Cash
Whether you have paid down enough of your mortgage, or the value of your home has appreciated sufficiently, you are gaining equity, or ownership, of your home. Refinancing with the aim to consolidate debt is really just a strategic cash-out refinance: the equity you use to get cash is earmarked to pay down any other debt you have outside of your mortgage. Now, that debt is represented by the larger total of your new mortgage loan, but is no longer a separate obligation.
The primary difference between a standard refinance and a cash-out refinance is the amount of the loan. Normally, you would only refinance the amount still owed on your home. When you want to convert your home equity into cash, you would refinance your mortgage for more money than what you currently owe. How much more depends in part on how much equity you have earned in your home.
The amount you can borrow against your home, compared to the total value of your home or the total amount of equity you have, is known as the Loan To Value ratio, or LTV. Typically you cannot liquidate the full value of your equity. Lending rules will limit your LTV to something around 85 percent, and may require mortgage insurance to be paid on top of your new mortgage payments. Additionally, your lender may require “seasoning,” or a certain period of time (usually you must have your home for at least 12 months), before allowing you to take cash out of your equity through your mortgage.
The rules and conditions for your refinanced mortgage and any cash-out you wish to take will depend on your lender, so be sure to bring up the subject early on if you think you will want to take advantage of this option.
Take Control of Your Debt
One of the main reasons people will consolidate their debt happens to be similar to why they refinance in the first place: to get lower interest rates. Auto loans and credit cards often carry a higher interest rate than a mortgage, so rolling that debt into a mortgage has the potential to save money right off the bat.
Even when debt consolidation doesn’t give borrowers a better interest rate, it does simplify paying the bills. Rather than balancing a multitude of due dates, minimum payments, interest rates, or possibly collectors, debt consolidation means you can put all your attention and money in one place. What is more, because mortgages are usually taken out for a longer term--15 to 30 years--the monthly payments are often lower than if you continued to pay down each debt separately.
Having a lower monthly bill means you can even send extra payments whenever possible, targeting your principal (as opposed to constantly wrangling with interest), and gaining greater control over your debt than before.
Approach With Caution
Mortgage interest rates are usually lower than those of other forms of debt, because the loan is secured: your home acts as collateral against your debt. When you consolidate your other debt through refinancing, you are essentially putting your home up as collateral for all the debt you roll into your mortgage. The risk of doing this depends on your ability to continue paying your mortgage on time.
One of the primary arguments against debt consolidation is that for many people, debt is the result of poor money management, rather than strategic investing. It is one thing if, for example, you have student loan debt because you invested in education as a means to getting a better job. On the other hand, if you routinely max-out your credit card without knowing precisely how and when you are going to pay it off, refinancing is not going to save you. Too often, homeowners who consolidate their debt take advantage of their clean credit card accounts to simply rack up more debt.
If accumulating debt is not a chronic habit, and you have an achievable plan to pay it off, you don’t fit the profile of those for whom consolidation is a poor option.
Another risk of consolidation is that the longer term of the mortgage loan gives interest more time to compound. Even at a lower rate, interest that grows over 15 or 30 years may end up costing more, overall, than if you had paid the higher rate in a shorter amount of time. Of course, paying debt off faster will take higher monthly payments. Whether consolidation is the best strategy for you really comes down to what you can afford now, and how you plan to manage your finances over time.
Always Have a Debt Reduction Plan
Debt consolidation should not be an act of desperation, or an impulsive decision. That kind of approach is how debt gets out of control and people fall behind on payments, or even end up risking foreclosure. Consolidation is a strategic route you may choose to take if you have done the math and the planning ahead of time, and determined you will be more capable of managing your debt this way, making the required payments without interruption.
All debt carries some risk, but as a homeowner you have the ability to use your equity to take greater control of your debt through consolidation refinancing. Talk to your lender, and consider your options, and see whether this will help you get on track to financial security.