Do you have debt? If so, you’re not alone. On average, Americans have about $38,000 in personal debt – excluding home loans. Only 23% of Americans say they have no debt at all. A refinance can help lower your monthly payments and free up money to consolidate your debt. But is a refinance right for you?
We’ll look at a few methods for refinancing and paying off debt. In this article, we’ll go over a few reasons to refinance, and we’ll outline the next steps.
Consider The Interest Rate On Your Debt
One of the main benefits of consolidating your debt with a refinance is that you’ll pay less in interest. A mortgage loan is one of the most affordable ways to borrow money. Mortgage rates are much lower than rates of credit cards, student loans and most other types of loans. A refinance allows you to pay off high-interest debt and convert it into a lower interest rate.
Let’s take a look at just how much money you can save when you refinance your loan. Say you have a $100,000 mortgage loan and $10,000 in credit card debt. Your mortgage loan has an interest rate of 3.5%. Your credit card debt has an interest rate of 17.78%. In a single month, your mortgage loan accumulates about $291 in interest.
Your credit card, on the other hand, accumulates about $148 in interest. Despite the fact that your credit card balance is 10% of the total amount you owe on your mortgage, you still pay half the interest of your $100,000 loan.
Now, let’s say that you refinance your $10,000 worth of debt into your $100,000 loan. Your new loan, worth $110,000, keeps the same 3.5% interest rate. That $10,000 now accumulates about $30 in interest instead of $148. You save more than $100 per month by paying off the high-interest card and rolling the debt into your home loan.
Consolidating also gives you an easy way to stay on top of your payments if you have debt on multiple cards. You only need to worry about making a single mortgage payment each month with most types of refinances. This can help you avoid missing a due date and damaging your credit score.
Your Refinance Options
There are different ways that you can refinance your mortgage loan. Let’s look at a few of your options for lowering your monthly payment or taking cash out of your loan.
A cash-out refinance should be your first consideration if you need to pay off a large debt. Before we go over what a cash-out refinance is, we need to talk about home equity.
Every time you make a payment on your home loan, you gain a bit of equity in your property. Equity refers to the percentage of your mortgage principal that you’ve paid off – it’s the part of your property that you own. For example, you might have $100,000 remaining on a home loan that was originally worth $150,000. In this case, you have $50,000 worth of equity in your home. Once you make the final payment on your loan, you have 100% equity in your property.
You take equity out of your home in cash when you take a cash-out refinance. In exchange, your lender assigns you a higher principal balance. Your new, higher-balance loan replaces your old loan. From there, you make payments to your lender like you did on your last loan.
Let’s say that you have a $100,000 principal loan balance and you have $20,000 worth of debt to pay off. You take on a loan worth $120,000 when you take a cash-out refinance. The lender then gives you the difference ($20,000) in cash after closing.
The cash-out refinance process is similar to the process you went through when you got your original loan. You’ll apply with your lender, go through underwriting and get an appraisal. Once all your paperwork clears and your appraisal is complete, you’ll close and sign on your new loan. Your lender will then wire you your funds.
There are three important things to remember before you take a cash-out refinance. First, you’ll need to already have enough equity in your property to qualify. Most lenders won’t allow you to take more than 80% – 90% of your home equity in cash. This means that if you have $50,000 worth of equity in your home, you may only be able to take $40,000 – $45,000 out. Not sure how much equity you have in your home? Contact your lender and request a balance statement.
Second, keep in mind that taking a cash-out refinance might require you to pay for private mortgage insurance again. PMI is a special type of coverage that protects your lender if you default on your loan. Your lender will require you to have PMI on your loan if you have less than 20% equity after you refinance. Make sure you can afford the extra PMI payment. Alternatively, you can wait until your cash-out refinance will leave you with at least 20% equity in your home.
Finally, remember that you won’t get your money immediately after closing. Your lender needs to give you at least 3 days after you close in case you want to cancel your refinance. This means that your loan technically isn’t closed until after this period expires. Most people who take cash-out refinances see their money 3 – 5 business days after closing.
Rate And Term Refinances
It can be easy to fall into debt if you’re having trouble making your monthly mortgage payments. A rate and term refinance can help you divert more money toward your debt without changing your principal balance. This can help you better manage your finances and pay down debt.
As the name suggests, a rate and term refinance changes your loan term and/or interest rate. Taking a longer term or a lower interest rate will lower the amount you pay each month. In some rare circumstances, you can even refinance your rate or term without a credit check or a new appraisal.
For example, let’s say that you have a $100,000 loan with a 4% interest rate and a 15-year term. Your monthly mortgage payment in this example is $739.69. Let’s say you refinance your loan to a 30-year term. Your monthly payment becomes $477.42. This leaves you with an extra $262 to put toward your debt without adding PMI or more money to your loan balance. Keep in mind that increasing your term will cause you to pay more in interest over time.
A rate and term refinance is faster than taking a cash-out refinance. You may be able to take out an FHA Streamline refinance if you have an FHA loan, or a VA Streamline refinance if you have a VA loan. Streamline refinances have less paperwork and looser requirements. Don’t qualify for a Streamline? You’ll follow largely the same process as a cash-out refinance.
First, you’ll compare lenders that offer rate and term refinances. Look at current interest rates, lender availability and reviews. Apply for a refinance and submit income paperwork to your lender. From there, your lender will help you schedule an appraisal and underwrite your loan. After underwriting and your appraisal finish, you’ll attend a closing meeting, pay what you owe in closing costs and sign on your new loan.
Home Equity Line Of Credit
A home equity line of credit is not a refinance, but it can allow you to unlock equity in your home to be used to pay down debt. HELOCs are also revolving, which means that your credit “refills” after it’s paid off. For example, you may take out a HELOC with a $10,000 limit and spend $7,000 and still use another $3,000 on the line of credit. However, if you pay back that $7,000 with any applicable interest, you have access to the full $10,000 again.
Every HELOC starts with a “draw period.” During your draw period, you can spend on your loan up to the limit. The only thing you need to pay back each month is the interest that accumulates. Most draw periods last 5 – 10 years. You enter the repayment period when the draw period closes. During repayment, you can no longer access your line of credit and you must pay your loan back in monthly installments. Keep in mind that you must make these payments on top of your regular monthly mortgage payments.
HELOCs are preferable to credit cards because they follow mortgage interest rates, which are lower than credit card rates. HELOCs allow access to your home’s equity without changing the terms of your original loan.
Use Your Home’s Equity Wisely
Remember that you reduce the ownership percentage of your home whenever you access your home’s equity. This means that you’ll either pay more in interest over time or you’ll need to make more payments before your mortgage matures.
You should never access your home equity for everyday expenses. This can quickly trap you in a cycle of debt. Instead, use your home equity for large, one-time expenses like covering medical bills or consolidating credit card debt. Consider all the financial consequences and make sure you can handle your new payments before you sign on your new loan. From there, stay on top of your payments and avoid falling back into debt.