However, even if you have a situation like this and paying off debt with a cash-out refinance loan makes financial sense, there are some downsides. You’re putting your home at risk if you can’t pay your new mortgage loan, as the lender could foreclose. And there could be substantial closing costs and fees to pay for the new mortgage loan. You need to be aware of the risks — and costs — before you move forward.
A mortgage refinance loan isn’t the only way to tap into equity in your home to pay off debt. Home equity loans also usually have lower interest rates than credit cards, personal loans, and similar types of consumer debt. But they work differently than cash-out refinance loans.
When you take out a home equity loan, you don’t get a big loan used to repay your current mortgage and keep the cash left over. Instead, you keep your current mortgage and take out a second smaller loan for the amount you need to pay off debt or accomplish some other goal. You can pick your repayment period, which might last anywhere from a few years to a few decades.
You could also take out a home equity loan and use the proceeds to pay off higher-interest debt
If you choose a shorter repayment timeline, or if you borrow only a small amount and pay it off early, you could save a lot of money this way. If you took out a $10,000 home equity loan to be repaid over five years at 5.25% interest and used it to pay off the $10,000 personal loan described above, the interest costs would come down to $1,391. This is a savings of $1,357.
However, there are some caveats here, too. First, you need equity in your home to qualify for a home equity loan, just as you need equity to qualify for a cash-out refinance loan. Second, home equity loan interest isn’t tax deductible unless you’ve used the proceeds to improve, repair, or buy a home — so you couldn’t deduct the interest on a home equity loan taken out to pay off debt. And, just as with a cash-out refinance loan, there are closing costs and fees to pay, and your home is put at risk.
Finally, if you take out a home equity loan with a long repayment timeline, you again face the situation where total interest costs could be higher even if you’re lowering your interest rate.
Look at the big picture before using home equity to pay down debt
Although it may seem attractive to take a cash-out refinance loan — or otherwise tap into home equity — to pay off high-interest debt, there are plenty of reasons to think twice about doing so. So, while you can usually do this, depending on your financial situation and the equity in your home, it’s not necessarily a good idea.
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But if you have debt that’s going to take you a long time to pay off anyway, it makes more sense to use a cash-out refinance loan to repay it. For example, I took out a 15-year cash-out refinance loan two years ago to pay off my remaining student loans. This made sense for me because I was on a 10-year repayment plan for student loans at a much higher interest rate and because I can deduct mortgage interest but don’t qualify for a student-loan tax deduction.