You can take out equity in your home to pay debt. In fact, it may be a very good idea to do this. However, you should also think about the disadvantages of taking on a new loan as well. Also, how much money you can borrow depends on your credit, other debts, existing equity in the house and the purpose of the new loan.

Refinance to Pay Off Debt

Whether you should refinance in order to pay off your other debts depends on a couple of factors. Your financial situation and your fiscal discipline determine if it is a good idea to restructure your loan. These are some of the important things to consider before you decide to refinance your house.

  • Most of your obligations are unsecured, but your house is collateral for a mortgage.
  • You can get a lower interest rate. But you will pay for it for 30 years (or the life of the loan).
  • You will pay thousands in closing costs.
  • If you don’t have enough equity in the property you may not get the loan.
  • It only makes sense when you plan to stay in your house for a long time.
  • Are you disciplined enough not to go into debt again?

Any time can be a good time to eliminate debt, but you should make sure that your financial situation can sustain the increased mortgage. In addition to that, it’s important to be honest with yourself whether you can keep from getting into more problems later.3

Good or Bad Idea

It is always a good idea to get rid of your debt as soon as possible. However, it may or may not be a good idea to trade one kind of debt for another. There are definite advantages to using your home’s equity to discharge other debts.

  • You will save on interest
  • You will have fewer monthly payments
  • The bank will loan you more money

Also, there are significant downsides to refinancing.

  • It doesn’t solve any spending problems
  • You will have to pay significant closing costs
  • It puts your home equity at risk

Whether these pros outweigh the cons for you depends on the nature of your debt and your discipline in paying off your debts.2

Advantages

You have important advantages when refinancing your home in order to eliminate other debts. For example, you may save on interest rates, have fewer monthly payments and be able to borrow more money.

Because your home secures your mortgage banks will give you a much lower interest rate than other types of loans. Unsecured loans, such as credit cards, have the highest interest rates. So, if you are going to use this strategy you should pay get rid of highest interest rate loans.

Once you roll your other loans into your mortgage you will have fewer payments. It will simplify your life if you consolidate your debts. Having just one loan to worry about may make things easier and less stressful for you.

You will be able to borrow more money by using your house as collateral than with other types of loans. Because the loan is secured by the equity of your house a bank will always loan you more money than other types of loans.

As you can see there are definite advantages to refinancing your house to pay other types of loans. Next, we will look at the downside issues with restructuring your home loan.

Disadvantages

While there are positive aspects about refinancing, you should also consider these disadvantages. It won’t solve any spending problems you may have. You must pay closing costs on the loan. It puts your home as collateral for the loan.

Refinancing to discharge debts won’t change spending problems. You should ask yourself why you got into debt in the first place. Was it an emergency? Was it a systemic problem? It won’t be a good idea to trade one type of debt for another if you are going to get into more trouble later.

You will have to pay thousands in closing costs for your new loan. You will also pay the loan for up to 30 years. Are the loans significant enough to make it worth it to pay those extra costs and pay the loan for that many years?

Finally, it puts your home at risk for foreclosure. If you can’t make your payments, your bank will take the home you live in.

You should think about each of these disadvantages before you use your home’s equity to pay off other debts. If you have a spending/debt problem, there are organizations that may be able to help. Local churches, Dave Ramsey, and Crown Financial Ministries are places you can go to get help with debt problems.

Cash Out Amount

How much money you can cash out when you refinance depends on several factors. The equity in your home, your debt to equity ratio, your credit score, and even the purpose of the loan will all affect the amount you can borrow.

The difference between the market value of your house and what you owe on your existing mortgage determines how much the bank will let you borrow. If you owe more than the value, then you will not be able to borrow any money. On the other hand, when you have significant equity the bank will provide a high loan amount.

How much debt do you already have? When you have high unsecured debts, such as credit cards, then the bank will not be willing to loan much money. If you have other debts, such as car loans, the bank will also consider these debts when they decide how much money to lend you.

Your credit score is very important. It shows the lending institution how prompt you are making payments. If you have good credit you will get a lower interest rate and a larger loan than when you have bad credit.

Finally, banks care about why you want the loan. If you spend the money for a vacation it will not help you get a higher loan. If you spend the money for improvements that increase the value of the home, they will loan you more money. If you are using the money to eliminate other financial obligations, you also get a higher loan.3

References

  1. Dough Roller
  2. Smartasset.com
  3. SFGate.com