Pros and Cons of Doing a Cash-Out Refinancing to Pay Off Credit Card Debt
By Eva Norlyk Smith, Ph.D.
September 30, 2010
Doing a cash-out refinancing of one’s home is one of the easiest ways to get out of high-interest credit card debt. Not surprisingly, millions of home owners take advantage of this option every year. However, this leap back-into-the-black does come at a price. Here are some of the pros and cons of refinancing your home to turn equity into cash and wipe out credit card debt.
Lower interest rates. With interest rates at historic lows, homeowners who haven’t refinanced their house within the last 4-5 years may well find that they can get a lower interest rate. Furthermore, consumers who have paid off a fair percentage of their current mortgage may be eligible for lower rates than the rates they started with. Paying mortgage payments on time over a couple of years can do wonders for one’s credit score, in turn leading to lower interest rates on loan refinancing. For example, a couple who took out a $150,000 mortgage at 7 percent three years ago may have access to a rate in the neighborhood of 5.5 percent or lower, depending on their credit habits.
Save money. Even if you don’t get a substantially lower mortgage interest, cash-out refinancing can still save a bundle of money. For example, a family with a credit card debt at 19.99 APR, who takes out a mortgage at 5 percent per year and use a $20,000 cash-out to pay down the credit card debt would save roughly 15 percent a year in credit card interest (19.99 percent minus the 5 percent paid on the mortgage), resulting in about a $3,000 savings a year until the credit card debt is paid off.
Accelerated debt payoff. Paying off a big chunk of one’s credit card debt will result in lower monthly payments. By keeping monthly payments at the same amount as before, you can save additional credit card interest and pay off the debt faster. This is even more so now, because with the new credit card laws credit card companies have to apply any portion of the monthly payment above the minimum to pay off the balance with the highest interest rate. Let’s take the example of a credit card with a 14.99 percent APR on purchases and 24.99 APR cash advances. Each month, the minimum monthly payment amount would be applied to the 14.99 percent purchase APR. However, any amount above the minimum payment would be applied to the 24.99 APR cash advance balance on the card until that balance is paid off. In short, any payment above the minimum results in an additional 10 percent savings in interest per year on the amount paid. So, if you’re paying $300 above the minimum each month, you’re essentially saving $30 more in credit card interest each month.
Better terms than home equity loans. Cash-out refinancing often results in better terms than home equity loans. While home equity loans are added on top of a current mortgage, cash-out refinancing replaces the initial mortgage altogether. In most cases, cash-out refinancing will offer consumers lower interest rates.
High closing costs. Cash-out refinancing is more expensive; closing costs typically run a thousand and up. This means that cash-out refinancing often only is worth it if a large amount of cash can be taken out and/or your interest rate can be lowered considerably (rule of thumb: at least by 1 percent). When considering which option to go for, carefully do the calculations to determine how much money can be saved through both loan options, and how long you can expect to make payments for.
Negative equity risk. In today’s still-shaky economy, the housing market could take another turn for the worse. Should housing prices take another dip, consumers mortgaged to the hilt could end up owing more money on their house than its worth. Consumers who end up with negative equity are tied down to a house they can’t sell, because they owe more on the house than they can sell it for.
Higher loan payments. Depending on the terms, cash-out refinancing is likely to result in higher loan payments. In addition, some housing loans, such as adjustable rate mortgages, can climb without much warning, turning a once-low interest loan opportunity into a pocket-draining debt with higher and higher payments. It’s important to take a careful look at your budget to make sure that you can meet the higher monthly payments, lest your home should be put at risk.
In short, while taking cash out of a home’s value can offer a quick solution to seemingly indomitable high-interest credit card debt, cash-out refinancing should be approached cautiously. Research the rates and regulations offered and carefully do the calculations to find out whether this option ultimately will lighten or heighten your debt load.