On the surface, refinancing a mortgage to consolidate other debts is a tempting option. However, there are potential drawbacks you need to account for in order to make refinancing and debt consolidation work for you.
The obvious appeal is that mortgage rates are usually lower than interest rates on other forms of debt. If you have equity in your home, refinancing can let you borrow against some of that equity to pay off other debts, such as credit card debt and personal loans. According to the Federal Reserve, when 30-year mortgage rates were at 4.20 percent recently, credit cards were being charged an average of 13.14 percent. So the potential to lower the interest rate on your debt is clear. In addition, debt consolidation can simplify your finances by replacing multiple payments with a single mortgage payment.
So what are the downsides of refinancing to consolidate debt? For one thing, it raises the stakes. While credit card debt and other obligations generally cannot result in any claims against your home, mortgage debt directly puts your house at risk. Another concern is that by converting relatively short-term consumer debt into mortgage debt, you could be lengthening the period of your indebtedness.
To help you focus on whether the benefits of refinancing to consolidate debt outweigh the potential problems, here is a checklist of issues you should examine:
- Have you looked at both 15-year and 30-year options? If you have a substantial amount of equity to work with, it probably means you are several years into your mortgage. If so, you should at least consider refinancing to a 15-year loan as a way of getting an even lower refinance rate.
- Have you factored in closing costs and prepayment penalties? The interest rate comparison is the most compelling part of refinancing, but you have to make sure there is enough of an interest rate gap to cover the costs involved in refinancing, including any prepayment penalties on your existing mortgage and other loans.
- Have you compared mortgage quotes? Just because refinance rates are generally lower than your existing interest rates, do not assume all refinance rates are the same. Shopping around for mortgage quotes can help you get the most out of this strategy.
- Can you readily meet the new payment schedule? Once you have figured out what the principal and terms of your new loan would be, take a good hard look at the payment schedule that would result, because this is where the risk is. It is generally safer to default on other forms of debt than on a mortgage, so make sure you are not jeopardizing your home by rolling other debts into your mortgage.
- Is the interest cost really cheaper? You may be lowering your interest rate, but you should check a full amortization schedule to make sure refinancing won't cost you more interest expense in the long run by lengthening your repayment period.
- Have you mastered your budget issues? Refinancing should not be a means of simply taking on more debt. It should be part of a broader strategy to help you live within your means.
The bottom line is that refinancing to consolidate debts can be a good idea; but like any financial technique, the idea is only as good as the numbers behind it.