What is a Debt Consolidation Mortgage & Should You Get One?

As of the beginning of 2022, the average American family is carrying slightly over $155,000 in debt including car loans, student loans and credit cards. That’s a lot of money and it’s no surprise that many Americans who own homes are considering a debt consolidation mortgage as a way to save money and pay down debt quickly.

Here at Addition Financial, we work with homeowners every day and as inflation has put a pinch on our wallets, we’ve been hearing a lot of questions about using a second mortgage for the purpose of debt consolidation. Here’s what you need to know about debt consolidation mortgages and some pointers to decide if getting one is the right solution for you.

What is a debt consolidation mortgage?

A debt consolidation mortgage might sound like something that’s different from other mortgages, but in fact it is simply another term for cash out mortgage refinancing. It allows any homeowner with more than 20% equity in their home to refinance their mortgage and use the equity to consolidate debt into a single loan.

The debt consolidation occurs when you use the cash based on your home equity to pay off other debts, including credit cards and other loans. It’s most commonly used as a way to reduce interest rates and pay off debt with a lower monthly payment than before the refinancing.

How does a debt consolidation mortgage work?

Debt consolidation mortgages are simple. If you meet the basic requirements for cash out mortgage refinancing, you can get a debt consolidation mortgage.

As we noted above, in most cases you will need more than 20% equity in your home because most lenders will lend a maximum of 80% of your home’s appraised value to protect their assets. You’ll also need good enough credit to qualify for a better interest rate, since there’s no point in refinancing if you can’t get a better interest rate than what you already have.

The process and mechanics of a debt consolidation mortgage are virtually identical to a traditional mortgage or traditional mortgage refinancing, but let’s walk through the steps quickly:

1. Calculate your home equity. You need to be sure that you have enough equity to allow you to borrow against it. Keep in mind that if the value of your home has increased, you have more equity than expected based on how long you’ve lived there.
2. Total your debts. It’s important to know what you owe to determine if you can borrow enough money to pay your debts entirely. If you don’t, it may still be beneficial to pay off some of your debt.
3. Gather documentation. Lenders require 30 days of paystubs, an asset statement, documentation of your outstanding debts, bank statements and other documents, and may require tax returns in some cases.
4. Research lenders. Keep in mind that there may be benefits to doing your cash out refinance with the same lender who holds your existing mortgage. For example, Addition Financial members can borrow up to 90% of their home’s value when they refinance while those whose first mortgages are with other lenders may borrow up to 80%.
5. Complete your refinance application. During the application process, you’ll need to complete all necessary forms and submit the documentation you’ve gathered to support your application.
6. Close on your new mortgage. If approved, you’ll need to attend the closing to sign your loan documents.
7. Pay your debt. After you have signed everything, your lender will use the funds to pay off your initial mortgage and pay any of the debts you plan to consolidate.

The most important takeaway here is that a debt consolidation mortgage will allow you to pay your debt with a single monthly payment and usually with a lower interest rate than what would be available with most credit cards.

What debt should you consolidate with a mortgage refinance?

Before we reveal some of the benefits and risks of debt consolidation mortgages, let’s review the types of debt you should consolidate with a mortgage refinance.

The first determining factor, and arguably the most important one, is the interest rate. Mortgage interest rates are often significantly lower than credit card interest rates, so most credit card debt should be under consideration for consolidation. (Of course, if you don’t have enough equity in your home for cash out refinance, you could always try to consolidate credit card debt onto a single card with a low interest rate).

Other loans may also be worth consolidating depending upon the interest rate. However, certain types of loans don’t make sense to consolidate. An example would be student loan debt, which typically comes with a lower interest rate than most credit cards. (As of December 22, 2022 the rate for federal student loans was 4.99%).

If you don’t have enough equity to pay all of your credit card debt, then we suggest using the Avalanche Method, which involves paying off the cards with the highest interest rates first and working your way down. This method enables you to save the most money in the long term.

What are the benefits of a debt consolidation loan?

You can reap some real benefits if you opt for a debt consolidation loan, as follows:

• Lower interest rates. Using a debt consolidation loan to consolidate high-interest credit card debt and loans means that you’ll have a lower interest rate than you did before consolidation and as a result, a lower total monthly debt payment.
• One monthly payment. It can be stressful and time-consuming to pay multiple debts on a monthly basis. With consolidation, assuming you can borrow enough to pay all your debts, you’ll have only one monthly payment to make.
• Improved credit score. Paying your debts can help you improve your credit score quickly because you’ll pay down your total balance more easily than you would with high interest rates adding to your payments.
• Reduced stress and anxiety. If you’ve been struggling to make monthly credit card payments, then a debt consolidation mortgage can help you eliminate some of your stress by making it easier to get out of debt.

Anybody who has been concerned about their ability to make monthly payments or fretted about high interest rates can potentially benefit from a debt consolidation mortgage.

What are the drawbacks of a debt consolidation loan?

Here are some potential drawbacks of getting a debt consolidation loan:

• Your house is collateral. When you refinance for debt consolidation, you’re using your home as collateral with the addition of your home equity — or part of it. That means that if you fail to make your monthly payments, you’ll be at risk of losing your home to foreclosure.
• Interest may not be deductible. With a traditional home equity loan or a HELOC, you can deduct interest payments on your taxes if you use the money for home improvements. That’s not the case when you use your home equity to pay off existing debt.
• You’ll pay closing costs. Like any loan or mortgage, a debt consolidation loan comes with closing costs that may range from 3% to 6% of the loan amount. You’ll need to pay these costs at the closing.

You’ll need to consider the drawbacks before you decide to get a debt consolidation mortgage to make sure you’re prepared to meet your responsibilities to your lender.

Should you consolidate debt into a mortgage refinance?

If you’re thinking about debt consolidation, then you may need some pointers to decide whether to consolidate your debt into a mortgage refinance. Here are some things that may help you choose:

• Calculate your total debt repayments at existing rates and compare them with your total payments at the quoted interest rates. Anybody with a significant amount of high-interest debt is likely to pay thousands of dollars less if they consolidate with a mortgage refinance.
• Total your existing monthly payments and compare them to your new payment. If your total debt payments for the month will be less with a mortgage refinance, then it’s a good sign that you can benefit from consolidating your debt.
• Factor your feelings about your existing debt into the decision. If you’re someone who finds it stressful to make multiple debt payments each month or you worry about the impact of high-interest debt on your financial future, then you can remove some of the stress with debt consolidation.
• Be realistic about making payments. If you’ve struggled to make payments and your new payment may still be a struggle, it’s important to take that into consideration. Remember, your house and home equity will act as collateral on the new loan, so you shouldn’t refinance unless you are sure you can afford to make monthly payments on time.

Refinancing your mortgage is a big decision, so we suggest thinking carefully about the decision and weighing the benefits and drawbacks carefully before proceeding.

A debt consolidation mortgage can help you pay off high-interest credit card debts and loans and reduce your monthly debt payments. It can also help you save thousands of dollars in interest as you pay down your debt and improve your credit score.

Are you considering a debt consolidation mortgage? Addition Financial is here to help! Click here to read about our mortgage refinance options.