Refinancing Your Mortgage to Pay Off Debt: Do It Right

By Chris Hiestand

Learn more about Chris on NerdWallet’s Ask an Advisor

Debt is a major problem for many American households — especially those that have credit card debt in addition to mortgages, auto loans and student loans.

U.S. households carry an average of $15,762 in credit card debt, and in 2015, they paid an average interest rate of 13.66% on it. Many cardholders pay higher rates on higher balances.

It might seem as though there’s no relief from high-interest balances, but you can take steps to lower your burden. For homeowners, one of them is to consolidate your debt and lower your monthly bills by refinancing your mortgage.

Using low mortgage rates to consolidate debt

You’ve probably noticed how low mortgage rates have been during the past few years. The 30-year mortgage rate hit 3.31% in November 2012, the lowest rate in history. Fast forward to March 31, 2016, and it inched up only slightly, to 3.71%.

This has been great for homeowners who want to lower their monthly mortgage payment by refinancing to a lower rate. But it can also help you get rid of high-interest credit card debt.

Almost 10 percentage points separate the average 30-year mortgage rate (3.71%) from the average credit card interest rate (13.66%). This is because credit card debt is perceived as riskier than mortgage debt, and credit card companies charge interest accordingly.

But if you can move debt that costs you 13.66% to a vehicle that charges you only 3.71%, you can effectively give yourself almost a 10% return on your money.

One way to do this is to perform a cash-out refinance. This type of refinance allows you to turn the equity you’ve built up in your home into cash that you can use for whatever you like. Most people use it to pay off high-interest debt, fund a large purchase or finance a home improvement project.

Many people like to consolidate credit card debt using a cash-out refinance because they can make fixed payments on it over a set period of time, rather than paying a revolving balance every month.

Calculate Your Mortgage Refinance Savings

Doing a cash-out refinance the right way

If you think a cash-out refinance might be a good idea, make sure you have enough equity that the cash you take out of your home won’t leave you with a loan-to-value ratio of more than 80%, post-refinance. Exceeding that ratio means that you’ll have to buy private mortgage insurance, which can easily cost 1% of the loan value every year. On a $250,000 mortgage, that would be $2,500 annually.

To calculate your current loan-to-value ratio, divide your current mortgage balance by the approximate value of your home.

(Current Mortgage Amount) / (Approximate Home Value) = Loan-to-Value Ratio

If you want to cash out some home equity to pay off high-interest credit card debt, add the amount of debt you’re paying off to the loan amount, like this:

(Current Mortgage Amount) + (Credit Card Balance to Pay Off) / (Approximate Home Value) = Loan-to-Value Ratio

Here’s an example. Let’s assume your current mortgage balance is $300,000 on a home worth approximately $450,000, and you’d like to pay off $15,000 in credit card debt. Your calculation would look like this:

($300,000 + $15,000) / $450,000 = 0.7 or 70%

Since your loan-to-value ratio is less than 80%, you can cash out enough equity to pay off your credit card debt without having to pay for mortgage insurance.

Potential downsides of a cash-out refinance

When you perform a cash-out refinance, you’re increasing your mortgage balance by the amount of credit card debt you’re paying off. This might cause your monthly mortgage payment to increase, depending on the interest rate and terms you qualify for.

You should also consider the length of your mortgage. If you’ve already paid several years off your mortgage, you probably don’t want to extend it to 30 years again. Instead, consider lowering the term to 25 or 20 years. The shorter term would lower your mortgage rate even further and save you a lot of money in interest. However, it could lead to a higher monthly mortgage payment.

Look at all your available options and find the loan that best fits your needs and goals.

Chris Hiestand is a personal finance expert at Lenda, a mortgage refinance site based in San Francisco.