Debt consolidation refinance: How it works, pros and cons

Erik J. MartinThe Mortgage Reports Contributor

April 19, 2022 - 8 min read

Is refinancing your mortgage to consolidate debt a good idea?

If you have lots of high-interest debt, the monthly costs can overwhelm your budget. For some, the best road out of this situation is debt consolidation.

Debt consolidation pays off your high-interest debt with one, lower-interest loan to save on interest payments.

At today’s mortgage rates, a debt consolidation refinance or home equity loan can be a great way to save money. But this strategy can also be risky, so be sure to weigh the pros and cons before applying.

How debt consolidation works

Debt consolidation should make your debt payments more affordable each month.

John Sweeney, head of wealth and asset management at Figure, explains: “The goal is to pay off higher-interest debt with a lower-interest source of borrowing. And it’s generally good advice to pay as little interest as possible on the debt you hold.”

High-interest debt typically comes from unsecured borrowing sources, like credit cards and personal loans.

“Debt consolidation is worth pursuing if you have steady and predictable income and want to make your monthly payments more affordable”

–Michael Bovee, debt management expert, Resolve

“Unsecured debt” means the lender has no collateral to recoup losses if you default on the debt. (Unlike a mortgage, which is “secured” by your home.)

It’s easy to get in over your head with multiple high-interest payments going to various lenders each month, especially when you have a lot of credit card debt.

Consolidating your debt by rolling your outstanding loan balances into a lower-interest mortgage can simplify matters and save you a lot of money.

“Debt consolidation is worth pursuing if you have steady and predictable income and want to make your monthly payments more affordable,” says Michael Bovee, debt management expert, and co-founder of Resolve.

What is a debt consolidation refinance?

The goal of consolidating debt is to lower your monthly borrowing costs. And if you can roll all your high-interest debt into a low-rate mortgage refinance, it’s one of the best ways to save money on your total debt payments.

With today’s low mortgage rates, you could probably use a mortgage with a sub-6% interest rate to pay off credit card balances that are charging you 18% to 25%.

Cash-out refinance to pay off debt

Homeowners who want to consolidate debt often use a cash-out refinance. This kind of loan uses your home equity — that’s the part of your home’s value you have already paid off — to generate your “cash out.”

You’ll be increasing your mortgage balance to provide the cash. Then you can use the cash out for any purpose, such as making home improvements or even making a down payment on a second home.

Of course, you can also use the cash to consolidate your higher-interest-rate debt, creating lower monthly payments compared to your existing debt load. This strategy could leave only one remaining loan to pay off: your mortgage, which should have a low interest rate compared to your credit card accounts.

Focus on high interest rates first

Funds from a cash-out refinance can also be used to pay off other major obligations, like student loans or medical bills.

But if your goal is to become debt-free faster, then your higher-interest-rate debts should take priority. The money you save can later be applied toward paying down the principal on lower-interest debt like student loans or auto loans.

Remember, there are closing costs

Keep in mind that refinancing comes with closing costs, just like your original mortgage did.

These costs often total 2-5% of the new loan amount, so look for an interest rate low enough that you’ll be able to recoup the upfront cost while saving on your external interest payments.

Your cash-out refinance costs can often be rolled into the loan amount, as long as there’s enough money left over to pay off the debts you were hoping to consolidate.

Debt consolidation refinance requirements

If you want to consolidate debt using a mortgage refinance, you have to qualify for the new loan. Eligibility varies depending on your current loan type and the type of cash-out refinance you apply for.

Home equity requirements

First, you need enough home equity to pay off your existing debts.

You’ll typically need significantly more than 20% equity to qualify for underwriting a debt consolidation mortgage. That’s because most lenders want you to leave at least 20% of your home equity untouched when using a cash-out refinance.

For example, 30% to 40% equity is needed to get 10% to 20% in cash out. If your home is valued at $300,000 and you still owe $270,000, you’d have only 10% equity which won’t be enough for most loans.

Credit history requirements

A conventional cash-out refinance — the most common type — requires a credit score of at least 620. If you’re unsure whether or not you meet the minimum credit score requirements, pull free copies of your credit reports from annualcreditreport.com.

FHA also has a cash-out refinancing program, which allows a lower FICO score of 600.

But be aware that taking out a new FHA loan means you’ll pay for mortgage insurance premium (MIP), including both an upfront fee and a monthly mortgage insurance fee. This will increase the total cost of your new loan and eat into your savings margin.

Veterans can cash out up to 100%

Qualified veterans and service members can consolidate debt via the VA cash-out refinance.

Unlike other refi programs, the VA cash-out loan lets you refinance 100% of your home’s value. Veterans and service members might qualify even if they don’t have enough equity for a conventional cash-out loan.

Other debt consolidation mortgage loan options

A cash-out refi isn’t the only way to consolidate debt into your mortgage. You could also get a home equity loan or home equity line of credit (HELOC).

• A home equity line of credit (HELOC) works a lot like a credit card; you can draw from the credit line as needed, but it’s secured by your home equity which means a lower interest rate

• A home equity loan gives you a lump sum at closing that you can use to pay off your debts. Home equity loans are paid off over a fixed period at a fixed interest rate

Both HELOCs and home equity loans can charge closing costs and/or origination fees.

HELOCs usually have an adjustable interest rate that’s based on the prime rate plus a margin; home equity loans usually have fixed interest rates.

What’s better: a home equity loan or cash-out refi?

“A HELOC is a great option if your primary mortgage is already at a competitive rate or you can’t qualify for a new mortgage currently,” says Sweeney.

In other words, if it’s not a good time for you to refinance your entire mortgage balance, HELOCs and home equity loans offer another route to get lower interest by securing your debts against your home.

With home equity loans and HELOCs you’d keep your current mortgage payments while adding a new monthly payment for the second mortgage loan.

Non-mortgage loans for debt consolidation

If you haven’t yet built enough home equity to secure a cash-out refinance or a home equity loan or line of credit, you will need a different way to consolidate debt.

Personal loans

A personal loan to consolidate debt works differently from a debt consolidation refinance.

“It is typically an unsecured loan, with fixed payment terms, used to pay off high-interest debt,” explains Bovee.

“Your interest rate on this loan is likely to be significantly lower than credit cards will charge. But it’s probably not as low as a debt consolidation refinance or HELOC would be,” he notes.

Balance transfer credit card

You could also use a balance transfer credit card to consolidate several high-interest debt payments into one, single credit card balance.

If you have excellent credit, or sometimes even good credit, you may be able to find a balance transfer credit card offering 0% interest for an introductory period.

But be careful: Credit card interest rates can change, unlike a fixed-rate mortgage. Read the card’s repayment terms carefully before signing up.

Debt consolidation mortgage pros

The obvious benefit of a debt consolidation refinance is that you’ll save money by lowering the interest rate on your outstanding debts. This could save you a huge amount of money in the long run.

“Say you had four or five credit cards with interest rates in the 18% to 25% range that are at or near their credit limit,” says Bruce Ailion, Realtor and real estate attorney.

“Assume you are making minimum monthly payments, too. Not only will you likely never pay these off. You’ll also pay a great deal in interest,” he continues.

Now imagine that you consolidated all of these debts into one loan with an annual percentage rate below 6%.

“You would save big money. In fact, the savings you’ll reap on paying less interest could be applied toward the (loan) principal,” Ailion says. “That means you can pay off the entire debt quicker.”

Consolidating your debt can also improve your credit score. It helps by lowering your “credit utilization ratio,” which is the percentage of your total credit limit that you’re using at any given time.

Plus, mortgage interest can be tax-deductible. Check with a tax professional if you’d like to claim this deduction.

Debt consolidation mortgage cons

Paying off high-interest credit cards with a low-rate mortgage refinance might sound like a no-brainer. But there are some very real pitfalls to watch out for.

Debt consolidation strategies have a high failure rate. And credit experts say that many who use home equity to pay off credit cards will then run their cards up again — until they’re in even worse shape than when they began.

Remember: “Unlike unsecured credit card or personal loan debt, mortgage debt is secured (against your home),” cautions Ailion.

“That means you’re pledging your equity as collateral for the money you borrow. If you happen to default and declare bankruptcy, debts that were previously dischargeable are now secured by your equity,” he explains.

Debt consolidation refinance: A worst-case scenario

A debt consolidation refinance carries some very real risks. In a worst-case scenario, a homeowner could refinance their debts and then run up new debts so high they can no longer afford monthly mortgage payments. They could face foreclosure and eventually lose their home.

It’s also important to remember a mortgage refinance involves resetting your loan term. If you were 10 years into a 30-year mortgage at the time of refinance, your remaining term would reset from 20 to 30 years.

This means you’ll be paying interest for an extended period of time. So despite short-term savings on your higher-interest debt, you could end up paying more when all is said and done.

Overall, a debt consolidation refinance can be a smart way to pay down debts at a much lower interest rate. But it requires a high level of discipline in making payments to avoid negative consequences.

Remember, you still owe the money

With any type of debt consolidation loan, the borrower should exercise caution and be disciplined with repayment. That’s especially true with a mortgage or home equity-backed loan, which could put your home at risk if you’re unable to make payments.

Borrowers sometimes get into trouble because when debt is consolidated, their prior credit lines are usually freed up. It’s possible to charge those lines to the max and be in debt trouble all over again.

Remember, consolidation does not mean your debts have been “wiped out.” They’re just restructured to be more manageable. The real goal is to be debt-free; a refinance or loan is just a means to that end.

Your next steps

Debt consolidation can be a legitimate road to debt freedom for careful borrowers. But you need to be aware of the potential pitfalls beforehand in order to avoid them and pay down debt successfully.

Before beginning your application process, try to:

• Seek help to get spending under control; credit counseling could help

• Make a higher-than-minimum payment on credit cards

• Consider zero-interest or low-interest transfers or personal loans as alternatives

Then start comparing mortgage refinance rates from a few lenders to learn how much you might be able to save by paying off your debts at a lower interest rate.