Debt is part of the life of most Americans, with a majority of Baby Boomers, Gen Xers, and Millennials stating that they all owe money. Not only are most Americans in debt, but it is also common to have many types of debt, including credit card debt, student debt, mortgage debt, medical debt and personal loans.
All of these debts are not created equal, however. Mortgages generally have much lower interest rates than most other types of debt. And, if you describe your deductions, you can also deduct interest on mortgage debt of up to $ 750,000 or $ 1 million, depending on the status of your tax return and when you bought your home.
When mortgage debt has a lower interest rate and is tax deductible, repaying another debt by refinancing your mortgage may seem like an attractive option. But can you do that? The question is whether it’s a good idea or not.
Can you use a mortgage refinance to repay a debt?
It is possible, under certain circumstances, to use a mortgage refinance loan to repay a debt. You can take a refinance loan with withdrawal to do this. The process is essentially to apply for a new mortgage larger than the current total balance you owe. If you owe $ 200,000 on your home, you can take out a $ 250,000 mortgage. You can then use the additional $ 50,000 you borrowed to pay other debts.
Your ability to take out a refinancing loan depends on the adequacy of your real estate capital and your eligibility for a mortgage based on other financial factors such as your credit score and your income. Most banks do not want your mortgage to exceed 80% of the value of your home. You may be refused if you try to borrow more than that. Some banks allow you to borrow more – up to 90% or even 97% of the value of your home – but you would need to pay for private mortgage insurance (PMI) if your loan-to-value ratio exceeds 80%. The PMI is an insurance that you pay to protect the lender from loss in case of impediment of the lender.
If your refinance loan is approved, the lender will repay your existing home loan and, upon closing the loan, you will get the difference between what you owed and the new amount you borrowed.
Is it a good idea to use a mortgage refinance loan to pay off a debt?
By refinancing your mortgage to pay off a debt, you could significantly reduce the interest rate on some of your high interest rate debt. If you have a 20% credit card debt, for example, you could significantly reduce the interest rate if you can qualify for a 4.25% mortgage.
However, by doing so, you are likely to be lengthening the repayment of your debt over a much longer period of time, depending on the debts you refinance and the time it would otherwise take to repay them. If you repay a personal loan of $ 10,000 at 10% interest over five years, you would 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 stretch your repayments for another 25 years. You would pay $ 7,709.84 in interest over three decades out of the $ 10,000 borrowed to repay your personal loan, even with a mortgage interest rate of 4.25%. As you can see, the long repayment term of the mortgage means that it makes no sense to use a refinancing loan to repay a debt that you would have repaid much more quickly.
But if you still have a debt that will take a lot of time, it makes more sense to use a refinancing loan to pay it back. For example, two years ago, I took out a 15-year refinancing loan to pay off my remaining student loans. It made sense to me since I was following a repayment plan for student loans at a much higher 10-year interest rate and I could deduct mortgage interest, but I could not claim a tax deduction for student loans.
However, even if you find yourself in a situation like this and paying down debt with a cash-back refinance loan makes sense, there are some disadvantages. You put your home in danger if you can not pay your new mortgage because the lender could avoid. And there could be substantial closing costs and fees to pay for the new mortgage. You must be aware of the risks – and the costs – before proceeding.
You can pay off your home equity in different ways – but that’s not always a good idea
A mortgage refinance loan is not the only way to tap into the equity of your home to pay off your debts. You can also buy a home equity loan and use the proceeds of the sale to repay a higher interest rate debt. Equity loans also generally have lower interest rates than credit cards, personal loans and similar debts. But they work differently than refinance loans by withdrawal.
When you take out a home equity loan, you do not get a large loan that is used to pay off your current mortgage and keep the available balance. Instead, you keep your existing mortgage and take out a second loan that is less than the amount you need to pay off your debts or achieve another goal. You can choose your repayment period, which can last from a few years to a few decades.
If you choose a shorter repayment schedule, or if you only borrow a small amount and pay it in advance, you could save a lot of money that way. If you incurred a $ 10,000 net worth loan to be repaid over five years at an interest rate of 5.25% and you used it to pay off the $ 10,000 personal loan described above, the cost interest would rise to $ 1,391. This represents a savings of $ 1,357.
However, there are some caveats here too. First, you need equity in your home to qualify for a home equity loan, just as you need equity in order to qualify for a refinance loan. Second, interest on equity loans is not tax deductible unless you used the proceeds to improve, repair or buy a home. You can not deduct the interest on a contracted equity loan to repay a debt. And just like a refinance loan with a withdrawal, there are closing costs and fees to pay, and your home is at risk.
Finally, if you take out a home equity loan with a long repayment term, you end up in a situation where the total interest costs could be higher, even if you lower your interest rate.
Look at the big picture before using the equity in your home to pay off your debts
While it may seem worthwhile to take out a refinance loan (or tap into the equity in your property) to pay off a high interest rate debt, there are many reasons to think twice. So while you can usually, depending on your financial situation and the equity in your home, this is not necessarily a good idea.