Mortgage Refinance to Pay Off Debt: Do It Right

Some homeowners refinance to pay off debt, such as credit card balances. They accomplish this with a cash-out refinance: getting a mortgage for more than they owe on the home, taking the difference in cash and paying off high-interest debt with it.

Consolidating credit card debt using a cash-out refinance allows you to make fixed payments over a set period, rather than paying a revolving balance every month. As a bonus, mortgage rates are usually lower than credit card interest rates.

Using a cash-out refinance to pay off credit card debt is also known as a debt consolidation refinance. You end up owing the same amount, but you pay off high-interest credit card debt and replace it with lower-interest mortgage debt.

» MORE: Shop current cash-out refinance rates

Can you refinance to pay off debt?

Before refinancing a mortgage to pay off debt, you'll need to be sure you have enough equity. If you end up owing more than 80% of your home's value after you refi, you'll have to buy mortgage insurance.

To avoid owing more than 80% of the home's value, you'll need to calculate your loan-to-value ratio. It's simple: Divide your mortgage balance by the approximate value of your home.

(Current mortgage amount) / (approximate home value) = loan-to-value ratio

» MORE: Loan-to-value calculator

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

(Current mortgage amount) + (account balance to pay off) / (approximate home value) = cash-out refinance loan-to-value ratio

Here’s an example: Let’s say you owe $200,000 on a home worth approximately $300,000, and you’d like to pay off $15,000 in debt. Your calculation would look like this:

($200,000 + $15,000) / $300,000 = 0.7167 or roughly 72%

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

» MORE: What home equity is and why it matters

How closing costs figure into your decision

Closing costs are another factor to consider before you refinance to pay off debt. Lenders and service providers charge hundreds or thousands of dollars in fees when you refinance a mortgage. That's money that you could otherwise use to pay down debt. Compare the closing costs with the overall interest savings on the consolidated debt. You want the interest savings to exceed the closing costs.

In other words, it may make sense to spend $3,000 on mortgage closing costs to save $12,000 in interest, but not to save $2,000 in interest.

» MORE: Closing costs calculator

Is refinancing to consolidate debt a good idea?

First things first: Before consolidating debt, you'll want to have a plan to keep from running up debt again.

Credit card debt is unsecured, which means that it's not backed by collateral. If you don't pay what you owe, the credit card company can't take your home. By contrast, mortgage debt is secured by your home, so the lender can take your home if you stop making payments. This means that when you pay off credit card debt with mortgage debt, you increase the risk of losing your home.

When you perform a cash-out refinance, you’re increasing your mortgage balance by the amount of other debt you’re paying off. Even if you refinance into a lower mortgage rate, your monthly house payments could increase, depending on the interest rate and terms you qualify for.

Consider your mortgage's term — the length of the loan in years. If you’ve already paid several years off your mortgage, you probably don’t want to extend it to 30 years again. Instead, consider shortening the term to 25 or 20 years. This strategy reduces total interest payments over time, even if it leads to a higher monthly payment.

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

» MORE: Know when the time is right to refinance