If you have equity in your house on one side and a pile of debts on the other, you have what amounts to a math equation. If you could take some of that high-interest credit card costing you 20% interest and convert it to something that would cost you only 4% interest, you would come out ahead. Far, far ahead.
Cash-Out Refinancing to Pay Off Debt
Before you go any further, you need to determine is worth it or not to refinance in the first place. There are many factors to consider here. If the answer is NO, then it is not worth it to refinance to pay off debt. However, if refinancing makes sense for you in general, it might be worth it to use cash-out refinancing to pay off debt.
Let’s look at an example.
Cash-Out Refinancing to Pay Off Debt Example
- Current credit card debt balance: $20,000 at 20% interest rate
- Current mortgage balance: $140,000
- Home value at the time of refinancing: $200,000
- Current available equity at 80% Loan-to-value: $40,000 (20% of $200,000)
- Current home interest rate: 4% over 30 years
- Refinance rate you can get: 4% over 30 years
Assuming the credit card minimum payment is 2%, your starting minimum payment would be $400. If you only paid the minimum, it would take you 109 months, and you’d have paid $23,360 in interest — staggering! This data alone should convince you to never, ever get into debt with credit cards.
Now, refinance your home at the 4% current rate and take the extra $20,000 in equity to pay off the credit card debt.
Your interest payments on the $20,000 in borrowed equity would be $14,538 over 30 years with a monthly payment of $95. You would save nearly $10,000 in interest payments to the credit card company.
To better compare the two, let’s assume you pay it down in 109 months instead of 365, your total interest would be $3,889 at $219 per month payment — a significant saving compared to the credit card.
This is the beauty of using the equity in your home to better your financial situation. You’re able to cut your monthly payment back by $181 while saving almost $20,000 in interest.
Note: I did not add in the closing costs, but even if you added $3,000 in closing costs you are coming out way ahead.
Cash-Out Refinancing Can Ruin Your Finances
As beautiful as it is to wipe out your credit card debt with a cash-out refinancing, there are significant risks involved. Dave Ramsey always says on his shows, “You can’t borrow your way out of debt.”
Nothing is truer.
You see, you can pull off the paying off debt with equity thing once. Just once. When you do it, you have to cut up the credit card, reel in your spending, and truly make a behavioral change with your finances.
If you don’t? You are financially doomed.
Let’s take a look at how the cash-out refinance could take a wrong turn.
Cash-Out Refinancing to Pay Off Debt Example
Here’s how the cash-out to pay off debt can take a negative turn. You pay off your credit card and celebrate. You get your budget in order and watch your finances for a few months.
Then an unexpected bill pops up. You get that credit card back out (that you didn’t cut up), and put the cost on there. You plan to pay it off next month.
Then something else happens. And another emergency hits you. And then your second cousin gets married and you have to buy a wedding gift. Then your hours at work get cut back.
Before you know it, you’re right back where you started except you have an extra $20,000 on your home mortgage. Your mortgage payment went up $95, which when considering a drop from the original $400 minimum on your credit card, was a great deal. But now your credit card is back to $20,000 at 20%. You’ve got another $400 credit card payment on top of the $95 increase in your home mortgage payment.
Oh, and you’re out of equity. You can’t take more money out of your house to pay off the debt. You’re going to have to do this the hard way: buckling down and paying extra principal on the credit card.
What About Home Equity Loan?
A home equity loan is slightly different from a cash-out refinancing. Instead of starting a brand new loan in the case of cash-out refinancing, you’re getting a second loan in the case of a home equity loan. Home equity loan generally has a higher interest rate but with lower closing costs. That said, they both have the same pros and cons when it comes to using your home equity to pay off debt.
A Better Way to Pay Off Debt
Since cash-out refinancing to pay off debt could be very risky, I would consider other options before going down that road.
- First, put together a financial success plan, e.g.,12 Steps to Financial Freedom and Personal Finance Success.
- Second, cut your spending, e.g., 40+ Ways to Save Money, Lower Your Bills, and Cut Expenses.
- Third, make more money, e.g., 40+ Passive Income Ideas and Ways to Make Money.
- Finally, use the money you saved and the extra money you earned to pay off debt, e.g., How to Get Out of Debt Fast.
Cash-out refinancing to pay off debt is a risky idea that can work if you genuinely make a change in your financial life. But it can also blow up in your face. Borrowing more money to get out of debt usually does not work. If you can be extremely disciplined — cutting up all of your credit cards, spending less than you earn, earning more money — then it can save you a ton of interest payments to the credit card company.
If you can’t handle that discipline, stay away.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.