If you’re thinking about a cash out refinance, you probably have a specific reason for doing so. But you should think twice before making the decision to borrow this money. Let’s discuss those reasons.
Cash Out Refinance to Consolidate Debt
This is a tricky decision that should not be entered into lightly. Most important difference between credit card debt and mortgage debt is that the former is a non-secured debt while the latter holds your home as collateral. Push comes to shove, you are putting your home, which is the corner stone of your life’s wealth building strategy, at risk. Is it worth the risk, even if you save a few thousand dollars in interest? To answer this question, please consider the following steps.
- First, you should make a list of all your debts and the total amount owed on them. The list can be either in Excel/Google Sheets, or you can go old school and use paper and some differently colored pens. Whichever is your approach to list management, make sure you have logged all of your debts in one place. You should have the following listed:
- credit card balances, amount you owe in total, monthly payment, monthly interest rate. Include all debt, remember student loans if you have any outstanding. Borrowing is costly, and interest rates on your cards will tell that story. We are aiming for minimizing the card balance, potentially by using your home equity.
- all your monthly bills related to your home such as mortgage and utility bills. Pay attention to the seasonality of bills and log the average monthly bill across a 12-month period. This goes towards fixed cost of living outside of your consolidating debt, it’s money you don’t have to spend.
- cost of living bills such as groceries, gas, restaurants, outings and shopping. List these as separate line items even if they are currently covered under your credit card bills. These provide most flexibility, as you have control over nice-to-have stuff. Borrowing to sustain a lifestyle is never a good idea as it catches up to you, whit high interest.
- your savings goals once your debt is paid-off.
- Now you are ready to analyze your financial situation, although the previous exercise would have already made some a-ha moments. Answer the questions below to arrive to the decision whether to refinance in order to consolidate debt:
- how much will I save in monthly interest payments if I refinance? There will certainly be an interesting amount to be saved on a monthly level with the cash out refinance. This is a major appeal to the process.
- how much do I save or lose on total interest paid for the life of the loan? For this calculation you can take an average of 5 years to pay off your credit cards. At this point you have the big picture in front of you regarding your overall money spent on servicing debt. Finally
- can I use the savings I made in monthly interest and lower payment to live my current lifestyle without getting back in credit card debt? The most important question for you to answer is if the cash out refinance is a one-time influx of cash you need to stand on your feet, or is it a bandage solution for a few years? If you cannot steer clear of credit card debt in future, you may be putting your home at risk for nothing. You would be better served to take higher interest rate and just pay it. You could look into some credit counseling services instead, reach out to your bank to negotiate your interest credit card rates, look for debt forgiveness programs, or debt management plans that target debt reduction.
Refinance to Improve Your Home
Here is where it gets interesting. Lots of people refinance their home in order to help fund the home improvement projects. The clear benefit to that is that your home will inevitably rise in value over time, but also due to the improvements made. In that case, depending on how well you plan it out, the improvements in part or fully pay for themselves. If your refinance extends the term of the loan as well, you may get away with the same monthly payments as you currently have.
- You should also contact contractors and ask for quotes for projects you want to finance with the money. Ultimately, the decision will depend on what you really need the money for.
- Once you have determined your overall costs, you take out your list making tools once again. This time around switch out your tools, if you were using Excel in the previous exercise, use a pen and paper and vice versus. Just kidding. Use what’s comfortable. Your project list should have the following:
- project costs
- new refinance deal details (obtained by speaking your mortgage lender, or other) with new interest rate, monthly payment and lifetime interest
- your exit strategy. In this section you should consider how long you intend to stay in the home you are improving. Once you have the years listed, you should increase your home price by average of 4% for each year you stayed in. This is the conservative approach. Adding in the improvements will add some value to the home but pay attention to what was the price per square foot for the home at your initial purchase. If you already bought at the high end for the neighborhood, you may not be able to get all your improvements accounted for. However, if you have some buffer, you can go ahead and increase your home price per square foot towards the higher end. This should give you a good idea of what you will be able to get back. Equity loans can be a great tool for you, if you get the right loan term and loan payment schedule.
Test Your OpinionLet’s look at an example of a borrower looking to repay their credit cards, go through debt consolidation with the goal of leveraging current historic low interest rates. We can take an average of $10K credit card debt, which is the starting point debt consolidation companies start reaching out. Borrower has 50% equity in their home. Consolidating additional $10K across a fixed rate loan lasting 15 years would cost $68 per month, using current 2.72% interest rate. Total cost of this loan would be $2,240 additional dollars in interest paid. Should this borrower take out a home equity loan or a new loan: line of credit to payoff the credit cards?
And there you have it! These two methods provide you all the information you may need to make the right decision about refinancing your home and taking equity out. Working on your credit score can be rewarding, as well as going through a repayment exercise of your unsecured debt. Your credit history will thank you for your efforts, and more importantly, you can avoid penalties when you have good credit. However, all the personal loans, debt consolidation loans, cash out refinance or balance transfer can do is be a tool for you to use. You are the one who needs to be committed to get out of debt. At the end of the day, there is also an emotional decision involved, but this article can’t help with that. Listen to your mind but follow your heart too. Only you can decide what is right for you.
If you would like more information on home loans, please visit our Home Loan center.
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