Getting out of debt may not mean paying out of your own pocket. Sometimes you just can’t afford that. Instead of paying outrageous interest rates and fees, though, you can consolidate. One way is with the equity in your home. It is called a debt consolidation refinance. You refinance your mortgage so you can wrap your debts into it. You then have less equity in your home, but you have less debt outstanding as well. We will look at how this works below.
How the Refinance Works
First, let’s look at how the debt consolidation refinance works. It is called a cash-out refinance. It requires you to have equity in your home. Generally, lenders allow you to borrow up to 80% of the value of your home. From that amount, you must subtract the outstanding amount of your first mortgage. Here is an example:
You have a 1st mortgage with a balance of $150,000. Your home is worth $250,000. You can borrow up to $200,000. Since you already have $150,000 outstanding, that leaves $50,000 for debt consolidation.
If your home was only worth $187,500, though, you would not have any room to take money out. You would be at your 80% maximum. This is why your home’s value and the 1st mortgage balance plays such an important role.
If you have the equity, you can apply for a cash-out refinance. You complete a loan application and provide the lender with the necessary documents. These include things like pay stubs, W-2s, and bank statements. The lender also pulls your credit. From there they decide if you qualify for a loan. If you plan to wrap your debts into the loan, they will figure out your debt ratio without your current debts. The lender will disburse the funds directly to your creditors, though.
If you qualify for the loan, the lender process and closes it. You sign documents and you have a new loan. The lender pays off your existing 1st mortgage lender as well as any creditors whose debts you included in the loan.
What Does the Debt Consolidation Refinance do for You?
The debt consolidation refinance does not eliminate your debts. It only transfers the debt to a new loan. In this case, it is your new mortgage. You still owe the debt, you will just pay it over a longer period. This has several consequences.
- You will pay more interest on the debt. Depending on the term of your original debt, it may take you longer to pay the debt off. A mortgage can have a term between 10 and 30 years. The longer it takes you to pay the debt, the more interest you pay.
- Your mortgage payment may increase. Since you will borrow more than you originally owed, your mortgage balance increases. This usually increases your payment too. It depends on the interest rate and term you choose, though.
- You put your home at risk. Since your home is the collateral for your mortgage, you could lose it if you do not make your payments. If you wrap unsecured debt into your mortgage, keep this in mind. Do not take a mortgage payment you may not be able to afford.
On a good note, a refinance could save you money. Usually, interest rates on mortgages are lower than those on unsecured debt. Again, this is because the lender has your home as collateral. If you do not pay the loan, they take your home. If you defaulted on a credit card, though, there is not anything for the lender to take. The only thing they can do is try to put a judgment against you. This could take years and often leaves the creditor empty handed.
How to Qualify for the Refinance
So how do you qualify for a debt consolidation refinance? It depends on the type of loan you need/want. You may choose from FHA, VA, and conventional loans, to name a few. They each have their own requirements. Generally, the maximum 80% LTV stands for each program. However, their requirements vary from there. In general, you need the following:
- Decent credit score – Usually a credit score of at least 680 or higher is necessary in order to qualify for a cash-out refinance
- Enough equity in the home – You will need adequate equity in order to roll your debts into your mortgage. Most lenders allow up to 80% of your home’s value. This usually isn’t an area lenders can grant exceptions.
- Reserves on hand – Lenders often like to see reserves on hand with a cash-out refinance. This helps them know you can make your payments if your income stops. They measure the amount of your reserves by the number of mortgage payments it covers.
- Consistent income/employment – Lenders prefer it when you have stable income/employment. Usually 2 years at the same job suffices. Of course, the longer you are at the same job, the better your chances of approval. If you do change jobs, lenders like to see increasing income rather than decreasing. If you make less money over the years, it makes you a riskier borrower.
Is a Debt Consolidation Refinance the Answer?
As we talked about above, debt consolidation does not mean debt elimination. You still owe the debt. So is it the right answer for you?
It depends on your situation. If you struggle to make ends meet, consolidating your debt will not help much. In this case, you might need debt settlement. It means you are in too far over your head and need some relief. You can work with a credit counselor to help you decide if this is the right option.
If you can pay your bills, but feel disorganized and overwhelmed, debt consolidation might work. Keep in mind, though, doing it this way could cost you more money. The shorter you can keep the term, the better off you will be. If you stretch the payments out over the full 30 years that most programs allow, you will pay a lot of interest. Chances are it would not take you 30 years to pay off a personal loan or credit card. Think about that long and hard before you consolidate your debt. If you can afford a shorter mortgage term, consider it. Not only will you get a lower interest rate, you will pay less interest over the life of the loan.
Other Available Options
If you do not want to include your debts in your mortgage, you do have other options. If you have credit card debt, you can apply for a 0% APR credit card. You can then transfer the balances of your existing credit cards to the new card. You get the benefit of having one bill for all of your debt. You also have the benefit of a 0% interest rate. However, that 0% rate will not last forever. Most cards provide it as an introductory rate. This could mean 3, 6, 9, or 12 months. Very few cards provide that rate for much longer than 12 months. After then, the rate increases based on the card’s terms. If you can pay the balance off before the interest rate adjusts, you benefit the most from this method.
If you have other unsecured debt, you can consolidate it with another private loan. Banks offer unsecured and secured loans for this purpose. Unsecured loans are usually personal loans. They carry higher interest rates than secured loans because there is no collateral. Secured loans are those that have some type of collateral. It does not have to be your home. Banks also offer them on cars, 401K accounts, and other assets. As long as there is an asset that the bank can use as collateral, they will. You can then use the funds from the loan to pay off your other loans. You are then left with one loan to pay each month. Again, keep an eye on the interest rate and the terms of the loan.
If debt consolidation does not work, you may need to speak to a credit counselor. They can help you with other options, such as bankruptcy and debt settlement. Neither option is good for your credit, but it can help you get out of debt. A counselor at a non-profit agency will have your best interests in mind while helping you get back on your feet.
If you do want to take advantage of a debt consolidation refinance, shop around. Different lenders have different requirements. They also have different fees. Do not focus only on the interest rate. Look at the big picture. How long will it take you to pay off the debt? How much will it cost in the end? Can you afford the payments? These are questions you should ask yourself. You do not necessarily have to use your current lender, either. Shop around and see what others have to offer. You might find a program you did not even know existed.