Cash-out refinance to pay off debt: Is it worth it?

Should you refinance to get rid of credit card debt?

Can you use a cash-out refinance loan to pay off debt? How about credit card debt? You bet! In fact, you can use the funds from a cash-out refinance for just about anything, including paying off debt from credit cards, medical bills, student loans, and home improvements, to name a few.

If you have enough equity in your home, then cash-out refinancing is an option. Equity levels rose by nearly 28% between 2021 and 2022, according to data from CoreLogic. Qualified homeowners could substantially lower their debt payments and increase their monthly cash flow using this method.

In this article (Skip to...)

• Paying off debt
• Benefits
• Credit card debt
• Drawbacks
• Alternatives
• Refinance rates

How to use a cash-out refinance to pay off debts

The process for a cash-out refinance is similar whether you’re borrowing to pay off debt or for any other reason. The steps are:

1. Work out how much cash you need

Start by determining exactly which debts you want to pay off and how much cash you’ll need to do so. Don’t borrow more than necessary since you’ll pay it off with interest over a long period.

2. Work out how much you can borrow

Mortgage lenders won’t lend you all your home’s value. Most require you to leave 20% of your equity untouched, which means your refinance loan will have a maximum loan-to-value ratio of 80%. The amount of cash-back you can get is calculated by subtracting your existing mortgage loan from your maximum refinance loan amount (your home’s value x 0.8). Those with VA loans can sometimes refinance 100% of their equity.

3. Apply for your cash-out refinance

This is pretty much the same as when you applied for your original mortgage loan. Expect an appraisal and a thorough investigation of your finances, including your credit score and credit reports. You’ll need to provide bank statements, tax documents, and any other evidence the mortgage lender requests.

4. Proceed to closing

Once your mortgage application is approved, the lender will complete the final steps necessary to close your loan. You’ll have some reading and signing to do.

5. Pay closing costs

Refinance closing costs are typically 2-5% of the new loan amount. You can usually roll your upfront costs into the new loan balance if you wish. But they’ll be deducted from the amount of cash you get at closing.

6. Funds received and debts paid off

With a debt consolidation cash-out refinance, the debts you elect to pay off will be paid along with the mortgage being refinanced. Any remaining funds after paying off both the initial mortgage and additional debts will be obtained either via wire transfer or physical check provided from escrow.

When you submit your application, let the lender know you’ll be consolidating your debts. That may help rather than harm your application.

Extra requirements for a debt consolidation refinance

You may be asked to show current statements relating to your debts and indicate how they’ll be paid off through escrow after closing. Show you’ve thought this through by preparing a summary of your debts, with the total sums owed roughly matching the amount you’re borrowing. If there’s a difference, explain why using a cash-out letter of explanation.

The debts you’ve built up may suggest that you have had problems managing your finances. So also show that you’re determined to take control of those once your existing debts have been paid down.

You might agree to get help from a credit counselor. Or you could build a detailed household budget that reveals areas where you could economize. Although these extra steps take time, it’s not unreasonable to have to show why you won’t be back in the same situation within a couple of years.

Benefits of cash-out refinancing to pay off debt

The objective of a cash-out refinance for debt consolidation is to reduce your monthly payments on debts. You do that by transferring those high-interest debts to your new mortgage, which should have a much lower interest rate.

The most common high-interest debt is credit cards. CreditCards.com estimates the average APR at the time of writing was over 18%. By contrast, the average 30-year fixed mortgage rate at the time of this writing was about 7%, according to Freddie Mac.

Example: Cash-out refinance to pay off credit card debt

Suppose you owe $40,000 in credit card balances. Your typical minimum payment would be $1,200 or 3% of the balance. But let’s say you pay down $1,300 a month to clear your debt faster. CreditCards.com’s calculator says it would take you 42 months to pay off that debt and would cost you about $14,000 in interest.

Now, suppose you paid the credit card debt down using a cash-out refinance. We’ll assume you have a 30-year, fixed-rate loan and will refinance to the same, and that your current mortgage balance is $200,000 while your home is worth $400,000. Finally, we’ll assume that you’re currently paying a mortgage rate of 6% while your new mortgage rate will be about the same.

Now let’s run the numbers using a mortgage calculator. You’re currently paying $1,200 a month in principal and interest. Once you’ve refinanced, your mortgage balance will be $250,000 (your old $200,000 balance + the $40,000 to pay off your cards + say, $10,000 in closing costs).

Debt consolidation can lead to serious savings

The higher mortgage rate on your cash-out refinance means you’ll pay $1,500 each month on your new home loan, just $300 a month more than previously. And you’ll no longer have to pay $1,300 a month in minimum card payments.

All told, that means you're saving around $1,000 per month by wrapping your credit card debt into your new mortgage balance.

Other debts with relatively high rates can provide worthwhile, but less dramatic savings. So run your own numbers for auto loans, personal loans, and other loans.

Should you use a cash-out refinance to pay off credit card debt?

Getting a new mortgage to pay off credit card debt may seem to be a drastic decision to some. However, in certain financial situations, refinancing may make sense. That’s because mortgage refinance rates are much lower than those of your credit card issuer. Having a lower rate on your credit card debt can save you thousands of dollars in interest.

However, there are still drawbacks to this strategy.

• Refinancing doesn’t address the core problem. If you fail to change your spending habits, then you run the risk of racking up credit card debt all over again. While taking control of your personal finances is important, a cash-out refinance is a costly way to do so, especially if the problem returns
• When you pay credit card debts with home equity, you own less of your home. Your home is an asset. Although there are multiple benefits of paying off high-interest debt, doing so with a mortgage refinance comes at the expense of a valuable financial asset
• It may take you longer to pay off credit card debt. When you roll your credit card balances into your mortgage loan, you’re essentially paying off credit card purchases over the next 30 years

Because their interest rates are so high, credit card balances tend to provide the biggest return when you use a cash-out refinance to pay off debt. So if you have enough equity in your home to qualify, then you may save money by using a cash-out refinance to pay off credit card debt.

When mortgage rates are higher and a cash-out refinance seems unattractive, you might explore a home equity loan or home equity line of credit (HELOC) instead.

Drawbacks of using a cash-out refinance to pay off debt

The first thing to realize about using a cash-out refinance to pay off debt is that you’re not really “paying off” the debt. You haven’t reduced the total amount you owe. You’ve merely changed from one type of loan to another, lower-interest type of loan.

Of course, there are big benefits to this strategy (as shown above). By rolling your high-interest debts into a low-interest mortgage balance, you could potentially save yourself a big chunk of money each month and create more room for savings and daily expenses.

But there are some inherent drawbacks to cash-out refinancing, too:

1. You're resetting the clock on your mortgage. Unless you refinance to a shorter loan term, you’ll be paying off your home for longer. Suppose you’ve had your mortgage for 10 years and refinance with a new 30-year loan. You’ll be borrowing (and paying interest) for 40 years. And, in the long run, that’s going to cost you
2. You're turning unsecured debt into secured debt. Your car loan is secured on your car. But card debt and personal loans are unsecured. Using a cash-out refinance to pay off debt means you’re putting your home on the line. And, if things go badly wrong, you could ultimately face foreclosure

Some homeowners also run into trouble when they use a cash-out refinance to pay off debt and then run their debts back up again. This can put you right back where you started — but without a cushion of available home equity to protect you.

None of this necessarily means you shouldn’t go ahead with your cash-out refinance. But these are serious points that require due consideration.

Before getting started, make sure you run the numbers, set a strict budget, and stick to it once your debts are paid down. A financial advisor could be a big help here.

Alternatives to cash-out refinance loans

There are a few alternatives to a cash-out refinance to pay off debt, and they may help you side-step some of the downfalls of refinancing. Other options to explore include:

1. Home equity loan

A home equity loan is a fixed-rate second mortgage that borrows against your available equity — without refinancing your existing home loan.

Compared to a cash-out refi, a home equity loan could help you save money because it would slash your closing costs. That’s because these loans are based on the amount of money you’re borrowing. And with a home equity loan, you’re not refinancing your entire mortgage.

You also wouldn’t be resetting the rate or the clock on your primary mortgage, which might be a smart choice if your current mortgage is largely paid down. But you would still be turning your unsecured debt into secured debt.

2. Home equity line of credit

A HELOC is a second mortgage, like a home equity loan. However, instead of paying out a lump sum at closing, it opens a credit line secured by your home’s value. You can borrow from the credit line, pay it back, and re-borrow throughout your HELOC’s draw period.

You might opt for a HELOC instead of a cash-out refinance when your existing home loan has a lower rate than the current mortgage refinance rates. Plus, HELOCs give you the flexibility to borrow only what you need. Cash-out refinancing requires you to refinance your entire loan, which can lead to larger monthly mortgage payments.

Still, a cash-out refi will typically offer lower rates than a HELOC. In addition, instead of two monthly payments — a mortgage payment and HELOC payment — you’ll only have one.

3. Personal loans

Personal loans are unsecured loans. Unlike a cash-out refinance, home equity loan, or HELOC, they’re not tied to your home’s value and you won’t risk losing the property if for some reason you can’t repay what you borrow.

Personal loans often come with low or zero setup fees. And they can close a lot faster since you don’t have to go through the mortgage application process. On the downside, though, personal loans charge significantly higher interest rates than secured loans. So the savings you’d see from paying off your credit card debt wouldn’t be as big.

4. Balance transfer cards

Transferring your high-interest credit card debt to a balance transfer card that offers a promotional 0% APR is another option. You will essentially pay zero interest on your current balances until the introductory period ends. However, if you have not finished paying down your debt, then you’ll pay the card issuer’s normal variable APR or you’ll need to move the balance to a new balance transfer credit card.

We’re talking here about borrowing big sums of money, often with long-term implications. So make sure you weigh your options carefully and choose a strategy that will benefit you in both the short and long term.

Today’s cash-out refinance rates

If you have high-interest debts eating away at your monthly budget, using a cash-out refinance to pay those debts down can have huge financial benefits. You could free up lots of cash for regular living expenses, savings, and even investing in your financial future.

Make sure you understand the pros and cons before getting started. As always, shop for the best interest rate on your cash-out refinance. The lower your new mortgage interest rate, the more you’ll save on all your debts.