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 payday installment loans Montana 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, 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.