If you have credit card debt, how do you know if a refinance can help you?

Practically speaking, credit card debt can be expensive, especially if you are paying 24% or even 36%. Seeing the massive interest payments that you pay every month, particularly if you have a high balance, can feel suffocating.

A mortgage loan officer or a financial planner may suggest that you refinance your home in order to pay off the debt. This is called a “cash out refinance” where you get a new mortgage to replace your old one, but borrow more money than you currently owe, and use the extra money for something else, like paying off credit card debt.

In this case, you are replacing one type of debt, credit card debt, with another type of debt, mortgage debt. Since mortgages typically have lower rates than credit cards – 4% sure seems a lot better than 36%, for example – it can seem like a no-brainer.

Here are three things to consider for deciding on whether to pay off your credit card debt with a refinance:

1) Pay close attention to the fees of refinancing in a cash out refinance

A loan officer may say to you, “there are no fees,” or, “the fees are financed as part of the refinance.” Here’s a tip: there are always fees in any home financing transaction. Ask to see what’s called a Loan Estimate as soon as you get a quote because this is a government form that is designed to be easier to read than the emails your loan officer will send you (I guarantee!) and the fees will be clearly marked.

What happens in a cash out refinance, is, say that you owe $100,000 on your mortgage, but you have $20,000 in credit card debt. You can do a cash out refinance and borrow $120,000, depending on what your home appraises for. The loan officer will add the fees to the amount you are borrowing, let’s say they are $7,000, and the total amount you borrow will be $127,000.

You aren’t paying any fees up front, but you are still paying fees, and now have a $127,000 mortgage. You want to take a good look at your monthly payment and decide how the savings with your credit card interest compares to the number of months you will have your mortgage, and the amount of money you will spend with your new rate.

2) With a new (refinanced) mortgage, you start all over again with your amortization, which can affect building equity in your home

What you want to consider is this: mortgage loans amortize. Amortization means that you are paying the most interest in the beginning of the loan. Let’s say you are already seven years into your current mortgage. You are now paying a greater proportion of principal than interest than when you first got your loan. If you refinance, you go back to the beginning of amortization, when the highest level of interest compared with principal is paid. What this means is that more of your money is going straight to the bank, instead of building equity in your home.

It is important when you do any kind of refinance, including a cash out refinance, that you understand the effects on building your equity.

3) Pay close attention to the term

If you’ve been in a 30 year mortgage for seven years, for example, you have 23 more years to pay off your mortgage. If you refinance, your loan officer may tell you to get another 30 year mortgage, as your payments will be lower than if you got a 23 year mortgage. This is true – the longer term mortgage you have, the lower your payments, as you are spreading it out over a longer period of time.

But, the longer your mortgage is, the more interest you will pay. So you’ll want to take this into consideration too.

Too often loan officers reduce refinancing into a monthly payment equation – “you’ll save x amount” or “spend y amount more per month” – but it’s more complicated than that. The reason they do this is because it’s simple to understand, and frankly, it’s easier to sell you on a refinance.

Educating customers sometimes ends in a bank losing your business, if it turns out a refinance isn’t in your best interest, so many times, you won’t hear these trade offs brought up!

So what is a consumer to do? You may be thinking, “how can I weigh the benefits of a cash out refi vs. the equity, interest, and term considerations? It all seems so complicated.”

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