Cash Out Refinance to Pay Off Debt
Is a cash out refinance to pay off debt a good idea, or not?
There are two sides to the conversation about refinancing to pay off debt. In this article, we’ll look at both sides, and give you enough information to make an educated and informed decision.
- Hitting the RESET button
- The TRUTH about your monthly savings
- The DANGER of paying off revolving debt
- 3 BENEFITS of paying off debt
- Cash out refinance EXCEPTIONS
- EMERGENCY refinance situations
- Working with an EXPERT
Hitting the RESET button
The greatest benefit of paying off your debt is being able to hit the reset button. It’s an opportunity for you to right the wrongs of the past, and make sure it doesn’t happen again.
Life happens. Sometimes, the only way out of a difficult situation is to borrow against your credit cards. Have you noticed that making the minimum payment each month does not pay off your balance very quickly? It seems like you’ll NEVER get that debt paid off, right?
Paying off your debt through a cash out refinance isn’t always the right answer. When there’s enough debt that you are unable to get it paid off anytime soon, you have a plan B, and it’s a good plan if you do it right.
The TRUTH About Your Monthly Savings
It’s very easy to be romanced by the thought of your monthly payments going down by paying off all of your debts with a cash out refinance.
The truth is that your payments are simply spread out over a longer period of time. One tactic often used by loan officers is to point out the high interest rates you’re paying on your debt, and convincing you that refinancing into a lower fixed rate save you money.
I would argue that you’re probably not actually saving money. Even at a lower rate, you are now paying off that balance over 30 years. Revolving, or even installment debt is unlikely to take 30 years to pay off, even if you are making the minimum payment.
Yes, your monthly payments are reduced. If that is the single most important goal of your cash out refinance, that benefit is definitely going to make a positive impact on your day to day life.
The DANGER of Paying Off Revolving Debt
You DO NOT want to do a cash out refinance if you are simply trying to free up credit card limits, only to have them charged back up again because of frivolous spending.
Nobody should tell you what to do with your home’s equity, but I can tell you that I’ve seen folks on both sides of this. It’s heart breaking to see a family relapse into debt after getting a second chance.
The BIGGEST mistake that you can make is to cancel your credit card after paying it off. This actually hurts your credit score, and can erase years of pay history in a single action.
If you pay off your revolving credit card debt, keep your balances low. Use your credit cards to only pay normal expenses like groceries and gas. Pay off the balance at the end of each month and you will super charge your credit scores!
It is not unusual to attempt to get into a position to qualify for a better loan, by first taking a loan that’s not everything you could qualify for.
The danger lies in working with an inexperienced loan officer that misses something, or does not counsel you on the best way to execute a two part refinancing strategy.
5 BENEFITS of Paying Off Debt
Certain debts make much more sense than others to pay off with a cash out refinance. In fact, paying off some debt is not considered a cash out refinance at all. We’ll cover that soon.
Pay off high interest, high balance revolving debt – Regardless of how you got there, high balances on high interest credit cards is a bad thing. Paying off revolving debt will give your credit scores a major boost, in addition to eliminating those monthly payments.
Pay off high interest installment debt – Unlike revolving debt, installment debt has a fixed payment regardless of the balance of the loan. Most loan programs will allow the underwriter to ignore the payment on any installment debt with less than 10 payments remaining.
You have the option of reducing your term to 10 payments, or paying it off completely and eliminating your payments now. Either option is a benefit to you.
Credit Reset – Probably the biggest “pay-off” for paying off debt all at once is that your credit scores will rebound much faster than if you slowly pay down your debt. If your credit scores are suffering now because of high balances on revolving debt, then you’re on the right track here!
Credit Debt to Deduction – Credit card debt is not tax deductible, but mortgage interest may be. When you layer this with the other benefits we’ve discussed, the additional tax deduction can be the benefit that the decision easy.
Reinvest to Reduce Term – Pro Tip: After paying off other debts, continue to make the same monthly payment as you did when you still had the debts. Apply this extra payment to the principal balance of your mortgage each month.
Watch the years drop off after stringing together a bunch of these increased monthly payments. In an emergency, you can make the minimum required mortgage payment, and pay extra when you can.
Cash Out Refinance EXCEPTIONS
A cash out refinance exception may apply when there are exceptions to the underwriting guidelines. Under these circumstances, you can pay off certain debt without the higher interest rates and closing costs of a cash out refinance.
*Pay off HERO or PACE loans – Solar equipment loans are toxic for most lenders. They are also incredibly expensive once you figure out that your property taxes, and therefore your mortgage payment increases significantly. Fannie Mae allows you to pay off a PACE or HERO loan with a no cash out refinance.
Pay off Student Loans – Fannie Mae conventional loans also allow you to pay off student loans and be considered a no cash out refinance. This guideline also applies for a parent that has co-signed for student loans. If it is on your credit report, you can pay them off with a no cash out refinance.
Paying off an EX through Divorce – If real estate is to be split up during a divorce, one spouse may have the option of refinancing the home to pay off the EX. In this case, as long as it is instructed and document in the divorce decree, you can refinance the home to pay off the EX and it would be considered a NO cash out refinance. If you take out money above and beyond what is needed to pay off EX, that would be considered cash out.
Paying off an Heir – When real estate is left to multiple heirs, either through probate or a trust, and one heir wants to buy out the other(s), this can be done as a NO cash out refinance. The buyout must be either court ordered, or documented in a will or trust.
*Fannie Mae, Freddie Mac, FHA, VA and USDA will not refinance around a HERO or PACE loan that is tied to your property taxes.
All of these underwriting guidelines have been updated in the last couple of years to address options for refinancing around these loans.
EMERGENCY Refinance Situations
A cash out refinance can also be used to put yourself in a situation to refinance into a better loan once you’re in a position to do so.
There is nothing worse than being unable to refinance into a better loan because your debt to income ratios are too high and your credit scores are too low.
In these situations, you really need to be working with an expert. Closing one loan to put yourself into a better situation to qualify for a better loan, means you have to have the experience to see into the future.
If your credit scores are too low for a conventional refinance, you can use a FHA cash out refinance, which tend to me much less expensive than conventional. Pay off debt, boost your credit scores, refinance into a conventional loan in 6 to 9 months.
An experienced loan officer can map this out for you. If you have to take a step backwards in order to take two steps forward, you better know that you have a professional in your corner.
If you are unable to use a FHA loan in the above scenario, there may be a portfolio loan solution that can put you in a position to qualify for FHA or a conventional mortgage.
The most important take away from this topic is that you MUST have a clear path to the next loan. How do you know if you have a clear path? Work with a professional!
Working With an EXPERT
You now have the necessary tools to make an educated decision about taking cash out of the equity of your home. There are a ton of benefits, and there are also risks.
As long as you know the risks, and the benefits outweigh these risks, you’re making the right decision.
I cannot stress enough, the importance of working with a professional anytime you consider financing on your home.
A professional loan officer can help you explore all of your options so that you’re making informed decisions about your largest investment, your home.
Getting Your Questions Answered
If you have any questions about refinancing your home, I can connect you with a professional loan officer that has years of experience with these guidelines.
You can get a direct introduction, and more information about our Expert Network here. You can also email me using the email address at the top of the site, or leave a comment or question below, and I will get back to you shortly.