The monthly expenditures of high-interest debt can be too much for your budget to handle. Debt consolidation may be the greatest way out of this dilemma for some people. To reduce interest payments, debt consolidation pays off all of your high-interest debt with a single, lower-interest loan.
A home equity loan or debt consolidation helps you save money at the current mortgage rates. However, this tactic can also be dangerous, so you need to consider the advantages and disadvantages before implementing it.
It might take a lot of time each month to pay back a variety of loans, especially if you have to do it by hand. One approach to merging those several loans into one is through debt consolidation. Keep reading to find out how debt consolidation works in 2022, its benefits and drawbacks, and decide if it is right for you.
How To Consolidate Debt?
Your monthly loan payments should become more manageable after debt consolidation.
The objective is to settle higher-interest debt using a lower-interest borrowing source, said John Sweeney, head of wealth and asset management at Figure. Additionally, it’s generally wise to pay as little interest as one can on any outstanding debt.
Personal loans and Credit cards are common unsecured borrowing sources for high-interest debt.
Unsecured debt is debt for which lenders have no collateral with which to offset losses in the event of a default. (As opposed to a loan, which is “secured” by your house.)
With many high-interest fees paid to various lenders each month, it’s simple to get in over your head, especially if you have a great deal of credit card debt.
It can be quite simple and cost-effective to consolidate your debt by transferring your existing loan amount into a mortgage with a reduced interest rate.
According to Michael Bovee, a debt management specialist and co-founder of Resolve, “debt consolidation is worthwhile to pursue if you have consistent and predictable income and want to make your monthly payments more affordable.”
What Is Debt Consolidation Refinance?
Lowering your monthly borrowing costs is the aim of debt consolidation. One of the greatest strategies to reduce your overall debt payments is to consolidate all of your high-interest debt into a low-rate mortgage refinance.
You could certainly utilize a mortgage with an interest rate of around 6% today to pay off credit card bills that are costing you 18% to 25%.
Refinancing With Cash Out To Pay Down Debt
A cash-out refinance is commonly used by homeowners who desire to consolidate their debt. This type of loan creates your “cash out” by using your home equity, which is the portion of your property’s value you have previously paid off.
To pay for the money, you will be raising your mortgage balance.
The money you withdraw can then be used for anything you like, such as home renovations or even a down payment on a second house.
Naturally, you can also utilize the money to consolidate your debt with higher interest rates, which will result in lower monthly payments than your current debt load. The only debt left after using this technique would be your mortgage, and this usually has a lower interest rate than your credit card accounts.
Concentrate First On High-Interest Rates
Money gotten from a cash-out refinance could also be utilized to settle other substantial debts, such as large medical bills or student loans
However, if you want to pay off your obligations more quickly, you should prioritize the ones with higher interest rates.
There Are Closing Costs To Keep In Mind.
Remember that closing expenses are associated with refinancing, much like they were with your initial mortgage.
Search for an interest rate minimal enough so that you can recover the upfront cost having saved on your external interest payments. These costs typically cost about 2-5% of the new loan amount.
So far as there is enough cash left over that can be used to pay off the debts you wanted to combine, your cash-out refinance expenses can frequently be rolled into the loan amount.
Requirements For Debt Consolidation And Refinancing
You must be approved for the new loan if you wish to consolidate your debt with a mortgage refinance. Depending on the sort of cash-out refinance you make an application for and your current loan type, you may or may not be eligible.
Home Equity Requirements
You must first have sufficient equity in your house to settle your debts.
In most cases, you’ll need a lot more equity than 20% to be approved for a debt consolidation loan. This is because, when employing a cash-out refinance, the majority of lenders prefer that you retain a minimum of 20% of your home equity.
For instance, 10%–20% in cash out requires 30%–40% equity. If your house is worth $400,000 but you still owe $370,000, your equity would only be 10%, which is insufficient for most loans.
Requirements For Credit History
A Minimum credit score of 620 is necessary for the most popular sort of traditional cash-out refinance. If you’re not sure whether you have the necessary credit score, acquire free copies from annualcreditreport.com, which provides credit reports.
Additionally, the FHA offers a cash-out refinancing option that accepts a FICO score as low as 600.
However, you should be informed that obtaining a fresh FHA loan entails paying a mortgage insurance premium (MIP), which consists of an initial payment as well as ongoing mortgage insurance costs. This will push up the overall rate of your new loan and reduce your range of savings.
Veterans May Receive Up To 100% In Cash.
Through the VA cash-out refinance, qualified service members and veterans can consolidate their debt.
The VA cash-out loan allows you to refinance 100% of the value of your house, unlike other refinancing options. Veterans and active duty military personnel may be eligible even if they don’t have sufficient equity to qualify for a traditional cash-out loan.
Additional mortgage loan possibilities for debt consolidation
There are other options than a cash-out refi for debt consolidation within your mortgage. A home equity loan or line of credit (HELOC) is another option.
- A home equity line of credit (HELOC) operates similarly to a credit card in that you can withdraw money as needed, but because it is backed by the value of your property, the interest rate is lower.
- You receive a lump sum from a home equity loan at closing that can be used to settle your debts. These home equity loans have fixed interest rates and a fixed repayment schedule.
Both home equity loans and HELOCs both have origination and/or closing fees.
Which is preferable, a cash-out refinance or a home equity loan?
Assuming your primary mortgage is already set at a competitive rate or maybe you’re currently ineligible for a new mortgage, a HELOC is a fantastic alternative.
This means that, by guaranteeing your debts against your house, home equity loans and HELOCs offer another way to acquire lower interest rates if it is not a good moment for you to refinance your full mortgage balance.
You would continue making your regular mortgage payments while also introducing new monthly payments for your other mortgage loan with HELOCs and home equity loans.
Non-mortgage loans for debt consolidation
To qualify for a line of credit, home equity loan or cash-out refinance, you must first accumulate enough home equity and an alternative means of consolidating debt.
- Personal loans
Debt consolidation refinancing operates differently from a personal loan for debt consolidation.
It is often a fixed-term, unsecured loan used to settle high-interest debt. This loan’s interest rate is probably going to be far cheaper than what credit cards would charge. However, it’s likely not as cheap as a HELOC or debt consolidation refinancing would be, the author observes.
- Balance transfer credit card
Another option is to combine many high-interest debt payments into a single credit card amount using a balance transfer credit card.
You might be able to discover a balance transfer credit card with 0% interest for an initial period if you have great credit, or perhaps even just good credit.
However, be cautious since, unlike fixed-rate mortgages, interest rates on credit cards can fluctuate. Before applying for the card, thoroughly review the payback terms.
- Mortgage debt consolidation experts
Debt consolidation refinancing will help save you money by decreasing the interest rates on outstanding loans, which is its most evident advantage. Long-term, this might result in significant financial savings for you.
Bruce Ailion, a realtor and real estate lawyer says, “Supposing you had four or five credit cards with interest rates within the range of 18% to 25% that were at or near their credit limit.
“Presume you’re paying the bare minimum each month, too. You won’t just probably never pay these debts off. You’ll pay a lot in interest as well,” he adds.
Consider consolidating all of these obligations into a single loan with a yearly percentage rate under 6%.
You may save a lot of money. The money you’ll save by paying less interest might go toward the loan’s principal, according to Ailion. That implies that you can eliminate the debt more quickly.
Your credit score might be raised via debt consolidation. Your “credit utilization ratio,” or the proportion of your overall credit limit that you’re using right now, decreases as a result, which is beneficial.
Mortgage interest may also qualify for a tax deduction. If you want to claim this deduction, go to a tax expert.
Debt consolidation mortgage cons
It might seem obvious to pay off high-interest credit cards with a low-rate home refinancing. However, there are a few very real dangers to be aware of.
Attempts to consolidate debt frequently fail. And according to credit experts, many people who utilize their home equity to pay off credit cards will reload them and end up in an even worse situation than before.
Keep in mind that mortgage debt is secured (against your property), contrasting personal loan debt or unsecured credit card, advises Ailion.
That implies you’re using your equity as security for the loan money. Debts that were once dischargeable would now be secured by your equity in the occasion of default.
Worst-case scenarios of a debt consolidation refinance
Risks associated with debt consolidation refinancing are quite significant. In the worst situation, a homeowner can refinance their loans and then accrue additional obligations to the point where they are unable to make their mortgage payments every month. They can be subject to foreclosure and ultimately lose their house.
It’s also crucial to keep in mind that a refinancing resets your loan term. At the period of the refinance, if you were ten years into a 30-year mortgage, the residual term would be reset from 20 to 30 years.
This implies that you will have to pay interest for a long time. Therefore, despite potential short-term savings on your higher-interest loan, you may ultimately pay more.
In general, debt consolidation refinancing might be a wise choice for consolidating debt and lowering interest rates. However, paying on time demands extreme discipline to avoid repercussions.
Keep in mind that you still are obligated to pay.
The borrower should use care and be strict with payments with any sort of debt consolidation loan. That is particularly true if you have a mortgage or a loan backed by your home equity, which might put your house in jeopardy if you can’t make payments.
Because their previous credit lines are typically freed up after debt is consolidated, borrowers can run into difficulty. You might use these lines to the fullest extent feasible and get into financial problems once more.
Also, note that debt consolidation just restructures your bills so that they are easier to handle. The primary objective is debt freedom; a refinancing or loan is only a tool to achieve that.
For cautious individuals, debt consolidation may be a valid path to financial independence. To effectively pay off your debt and prevent any hazards, you must be aware of them in advance.
Try these things before starting the application process:
- Seek assistance to rein down your expenditures; credit counseling may be helpful.
- Pay more than the minimum amount due on your credit cards.
- Alternatives to credit cards include personal loans with no interest or reduced interest.
Then begin comparing mortgage refinancing rates offered by a few lenders to find out what amount you may well be able to save by repaying your loans at a reduced interest rate.
About the Author
Brian Quigley has been in the Denver mortgage industry since 2003. Customer satisfaction has been his top priority while guiding clients through the home loan qualification process. He is proficient in all types of mortgage financing including FHA/VA, Conventional, USDA, Jumbo, Portfolio, 1031 Exchanges, Reverse Mortgages, Refinancing, Construction loans, and FHA 203K loans.