The Scoop on Using a Cash-Out Refinance to Consolidate Debt

Cash-out refinancing for debt consolidation can be a great option for a homeowner who has been paying their payments faithfully for a while.

A cash-out refinance is also great for a homeowner who now realizes that the loan they used to secure the home was not compatible with their needs.

If you fall into the first category, you can use the equity you've been building over the years to pay off a big bill, do a major upgrade to their home, or -- yes -- consolidate your debts.

If you're in the second group, you're probably getting desperate to get out of your mortgage. Whether you're about to be hit with a balloon payment or you're dealing with a pay-option ARM that’s created a nightmare scenario over the years, refinancing may be able to help you out.

Does it Make Sense to Use a Cash-Out Refinance to Consolidate Debt?

As of 2018, these kinds of refinancing situations are sort of a double-edged sword. On one hand, rates are still reasonable and it makes sense to pay off higher interest rate credit with lower interest rate loans.

But on the other hand, it wasn’t so long ago that the entire bottom dropped out of the real estate market -- and it could happen again as the economy shifts. In that second situation, it would be best to maintain as much equity as possible to prevent your home from being underwater.

Refinance Restrictions: How Can I Use the Funds, and Do I Qualify?

As far as restrictions for cash-out refinancing go, there really aren’t any. Fannie Mae has a program that’s specifically for refinancing student debt into your loan, it’s called a Student Loan Cash-Out Refinance. With this sort of loan, you don’t get cash back necessarily, the majority of the money goes straight to the student loan servicer.

But with most programs, you can spend the money on anything you need to spend it on, whether it’s a smart move or not.

Credit Score and Cash-Out Refinance

Your credit score can be in the low 600s for a minimal conventional refinance, but anything above 680 will be a cakewalk for you. The FHA is less concerned with credit scores as it is with on-time payments. A seasoned history of 12 payments made within the month due for the past year is generally satisfactory.

A homeowner will need to remain within the same debt to income ratios as with a purchase. For conventional loans, that's under 45 percent, but ideally under 36 percent. FHA refinance programs are a lot more forgiving, but they still maintain the 31/43 ratios (31 percent for all debt minus housing, and 43 percent including housing).

Just like when securing an initial mortgage, there are plenty of small nuances and compensating factors, but they are entirely too numerous to list here. The biggie, though, is that a homeowner cannot refinance until their loan is 6 to 12 months old, depending on the program. Some programs will only refinance their own kind (FHA to FHA refinance, for example), others will only refinance other types of loans (FHA to conventional refinance), so there’s really something for every situation.

When Does it Make Sense to Refinance?

Refinancing really makes the most sense when rates are going down or a major improvement is planned for the home that will immediately increase its value.

Learn more: When to Refinance Your Mortgage

Consolidating or paying off debt, by contrast, is a risky move because you can’t be certain your home will maintain its value over the new term of 10, 15 or 30 years.

However, if your debt is small and can be easily covered without crossing the 80 percent loan-to-value threshold, it may be better not do opt for the refinance. The reason? Once you cross that line, your debt repayment is not only costing you a percent of the new loan’s interest, it’s costing you mortgage insurance you’d not otherwise have to cover. This is something to consider carefully because it may be cheaper to leave the debt alone and pay whatever interest rates are already there, or call the creditor and ask for financial assistance.

The right time to refinance for any reason, frankly, is passing. With interest rates going up in 2018, a homeowner will find that their lower interest assumable mortgage has substantial value when they go to sell. If rates hit six percent and their note is at three, selling the house with the mortgage intact will absolutely not hurt anyone. In fact, it could drive a bidding war or at least attract a buyer in the blink of an eye.