7 Things to Reconsider Before a Cash-Out Refinance On Your Mortgage: Will It Help?
Carrying high amounts of debt can result in stress and an overwhelming sense that you will never get out from under the heavy burden you are carrying. When this happens you may begin to look for a short cut. What are the options for reducing debt quickly, offering you financial relief for your short term needs?
Unfortunately, many options that present themselves are not in your long term best interest. While refinancing debt through your mortgage may be a popular option, it is almost always not a good option. So while you may feel exhausted trying to juggle the never ending parade of bills, there are other more advantageous options that will offer you with immediate debt relief and build your long term financial health at the same time.
The justifications many consumers use for converting credit card debt to a mortgage include the tax deductibility of the debt and the lower interest rate. While these are enticing reasons to refinance your mortgage, here are 7 reasons why you should reconsider:
- High cost of conversion. Mortgage refinances can cost several thousand dollars depending on how much your refinancing. Figure refinance costs can be between 2% and 5% of the mortgage balance with 1% to 1.5% as an origination fee. From there you have attorney costs, filing fees, appraisal and the list goes on. You may also find you need to fund your escrow account and wait for the previous escrow to be refunded to you. This can add easily another thousand dollars to your costs. Some who refinance strive to keep fees down in exchange for a higher rate. This strategy often defeats the benefits for the refinance.
- Higher Mortgage Rate. One of the key benefits of a refinance is to lock in a lower rate for the long term loan. There are many variables that are factored into the rate you receive. A few of these include your credit, the loan amount, the loan to value, if the home is your primary residence, points paid, and whether you are receiving cash out. A cash out option will always charge a premium rate over a straight refinance. This occurs regardless of what the funds are used for. Whether you are combining a first and second mortgage or paying off credit card debt, any cash beyond the original mortgage are classified as a cash out.
- Band aid for the problem. Ultimately a refinance does not actually pay off any debt, it simply transfers it. This action does not eliminate the behaviors and problems that caused the debt accumulation to begin with. A refinance can also feel like a windfall. You suddenly have your debt “paid off” and your credit cards have zero balances. The temptation is for a resurgence in spending. This is especially true if you have been cutting back to keep bills paid for an extended period of time. If behaviors do not change, then you could end up running up even more debt resulting in double the debt and a home with no equity.
- Mortgage insurance. One of the advantages of paying down mortgage debt is the elimination of mortgage insurance once you have 20% equity. Just like a purchase, when a refinance increases your mortgage balance over the 80% mark, you could find yourself adding a couple hundred dollars in additional payments to cover the cost of mortgage insurance. These extra costs do not go towards interest or reducing debt balances. It is simply an insurance premium to cover the higher risk of default because of the lower equity. Lenders may lend up to 90% or even 100% for a primary residence, which would require a mortgage insurance or PMI premium.
- Exchanging long term debt for long term debt. Credit cards can take up to 30 years to pay off when you only make the minimum payment. While you might be saving money on interest with a mortgage refinance, you are also dragging out the credit card debt over 30 years. This strategy will still lead to paying double or more from the initial expenditures. It can also push back your mortgage that you have paid on for years to a longer term debt, in an effort to keep payments down. This strategy is like going backwards on both your credit card and your mortgage debt. Many credit card repayment plans will schedule credit card debt pay offs within 5 years, resulting in lower total debt payments and a better long term solution.
- Trading unsecured debt for secured debt. Unsecured debt limits a creditor’s ability to collect the money if you are unable to make payments. Typically, a credit card company is willing to negotiate a lower payoff, or will adjust the terms in order to receive the maximum amount of payments. They do not have much leverage outside of suing you. If you are unable to pay off the debt and long term prospects are dim, you have the option of bankruptcy and having the debts discharged altogether. This fact motivates lenders to work with you on payoff options without putting your home at risk.
When your home is the collateral for the loan, you may get a lower interest rate, but you also risk losing your home if you begin missing payments. Lenders are less willing to negotiate lower payments and payoffs because they know they can foreclose on the home. Home’s generally appreciate in value enabling the bank to sell your home to pay off the outstanding loan balance. This option could leave you with no place to live. Moving debt from unsecured to secured carries with is substantial risk.
- Lose equity in your home. Anytime you use your home equity as an ATM, you are paying the price by sacrificing equity. This could make your home more difficult to sell or create a situation where you are unable to sell based on market prices. When you sell your home you generally must come up with both closing costs and the realtor’s fee which adds up to thousands of dollars. Add the cost of moving and a down payment or deposit for the next residence and you could find yourself stuck in your home due to the refinance. The lower equity can no longer be used to downsize to a smaller home or used for other emergencies, if needed.
Home equity is earned through paying down debt and an increase in value based on home improvements and improving market conditions. For this reason, a home is often considered an investment. Taking money out of your home should be done with caution as you put your home at risk. If for any reason you are unable to make the debt payments, you could lose your home to foreclosure. Credit card debt, regardless of how high it is, will not result in the loss of your home as long as it remains unsecured debt.