Do you have a lot of debt? Student loan, car loans, credit card debt? Are you considering taking out a debt consolidation loan where you get a new loan that pays off all the other debt? These types of loans are popular because you get to put various different loans into one payment, which makes your life easier, and they are often at a lower rate than credit card debt, so you save money. But what kind of debt consolidation loan should you get?
Option 1: Personal Loan
Many people take out a personal loan. These loans do not require that you have any equity in your home because they are not secured by your home – they’re made based on your income and credit. But personal loan rates are typically higher and with shorter terms than mortgages. For example, if you took out a $30,000 personal loan today, you should expect to pay a rate of 5.95% and the term will only go as long as seven years. Let’s say if you took this loan out for five years. Your monthly payment would be $862.62, and over the life of your loan, you would have paid over $21,000 in interest.
Option 2: Cash-Out Refinance
Is there another way to consolidate debt? Yes, if you own your own home. You can take out a debt consolidation mortgage. These types of mortgages are also known as “cash out refi’s” because you are refinancing to take cash out of your home. For example, if you owe $150,000 on your mortgage, and your home is worth $225,000, you could potentially be approved for 80% of your home’s value or $180,000. You would get a new loan of $180,000, pay off your current loan of $150,000, and walk away with cash in hand of $30,000. And yes, you still own your home.
What would your rate be on this new loan? As with getting any mortgage, you would shop around for the lowest rate. Let’s say you end up with a rate of 3.99%. That rate is clearly much lower than the 5.95% rate for a $30,000 personal loan. And since the 3.99% rate is a 30-year fixed, your payments are lower than with a personal loan. The 30-year fixed at 3.99% for $180,000 costs you $1,141.64 per month. You’re borrowing six times as much and only paying $279.02 more per month. Clearly, a debt consolidation mortgage is cheaper than a personal loan.
How Much Equity Do You Need to Be Able to Do a Cash-Out Refinance?
Most loan programs allow you to borrow up to 80% of the value of your home. However, you need to qualify to carry the increased debt. Underwriters look at a cash out refinance by calculating your new payment compared to your income and they make the assumption that you are using the loan proceeds to pay off the specific items of debt you have indicated on your loan application. So if you are cashing out $30,000, you will need to indicate which credit cards and which loans are being paid off. If the debt exceeds $30,000, you either need to pay off less debt or increase your loan amount.
Is a Debt Consolidation Mortgage Always the Best Way to Go?
It depends on the following four factors.
- Closing costs associated with refinancing. Refinancing isn’t cheap. Depending on where you live, closing costs such a title insurance, recording fees, origination fees and closing fees could add up to several thousand dollars. A personal loan by comparison has virtually no closing costs (typically just an application fee). So if you want to consolidate $30,000 worth of debt and you determine that your closing costs could add up to five thousand dollars or more, you might decide not to refinance and take the personal loan instead.
- How close you are to paying off your current mortgage. If you are near the end of a thirty year fixed, you are paying mostly principal (compared to in the beginning, when you are paying mostly interest). When you refinance, you start all over again with a new amortization schedule. In the example above, you have a new $180,000 mountain of debt to chip away at. Whereas if you took a personal loan, you would leave your mortgage untouched and you would continue with amortizing your loan at the same pace.
- How able you are to pay off a personal loan in the near future. The third factor depends on your personal situation. Let’s say over the next few years, you are anticipating a raise or your partner will be going back to work. You know your income will go up. You have a mortgage that you just closed on and the rate is good, but you have credit card debt and student loan debt you want to consolidate. You look at rates for doing a cash out refinance, but even though personal loan rates are higher, you know you will be able to pay the loan off in a few years. Therefore, for you, taking a higher rate personal loan is actually a smart move compared to taking out a new mortgage by refinancing.
- Risks associated with using your home as a piggy bank. This is the most important one: is it financially sound to use your home’s equity to pay off debt? That really depends on how responsible you are and how the housing market is where you live. Some people refinance every time values go up and they continue to take every penny of equity out of their home. If values turn around and go down, and if they have to sell their home, they will be faced with the proposition of selling their home and bringing money to the table because they now owe more than their house is worth.
A debt consolidation loan can work for you. Make sure you understand the pros and cons before using the equity in your home to pay off personal debt.