Debt Consolidation 101: How to Decide Between Refinancing & HELOC

Are you wondering what you can do to pay off your debt with a lower interest rate than what you have now? If so, then you may be interested to learn about the option of paying down your debt with either mortgage refinancing or a home equity line of credit (HELOC).

Our Addition Financial members sometimes ask us about debt consolidation that uses home equity. If you have credit card debt or you’re interested in student loan consolidation, you might be weighing a mortgage refinance vs HELOC and wondering which option is best.  Here’s what you need to know.

What is the difference between refinancing a loan and a HELOC?

Debt consolidation can be done in a variety of ways, but if you own a home and have enough equity to borrow against it, two of the most common choices are cash out mortgage refinancing and home equity lines of credit (HELOC). There are some key differences you should understand before you decide.

What is cash out refinancing?

Cash out refinancing is mortgage refinancing where you apply for a new loan that includes the debt remaining on your original mortgage plus borrowing against your home’s equity. For example, if you have a home valued at $575,000 and you have $200,000 of equity, you could refinance your home loan and add $100,000 of new lending against your equity. 

People most often choose this option when they have substantial equity and can qualify for a lower interest rate than the rate on their original mortgage. At the closing, they get the amount they’re borrowing against their equity as a lump-sum payment they can use to pay their debts or other purposes.

What is a HELOC?

A home equity line of credit, or HELOC, is a form of borrowing that uses home equity as collateral. A HELOC comes with a total limit that represents the maximum amount that may be borrowed. There is a withdrawal period, during which the borrower may withdraw funds up to the limit, and a repayment period, when the amount borrowed must be repaid.

What makes a HELOC different from cash-out refinance is that HELOCs are a type of revolving credit. During the withdrawal period, borrowers may borrow, repay, and re-borrow funds as many times as they want. They pay interest only on what they borrow.

What are the benefits and risks of debt consolidation with refinance?

Let’s start with the benefits of using a cash out refinance to consolidate your debt:

• You’ll have a lower interest rate with cash out refinance than what you have on credit card debt.
• A lower mortgage rate will translate to a lower monthly payment.
• You’ll eliminate the stress of making multiple debt payments each month.
• Your monthly payments will be predictable.

Here are a few potential downsides to consider:

• If you borrow money beyond what you need to consolidate your debt, you may be increasing your debt load.
• Interest from home equity borrowing is tax deductible only if you use the money for home improvements.
• If you don’t address your spending habits, you could be at risk of running up new debt and not improving your financial situation.
• Your home is collateral, so if you miss payments you could lose your home to foreclosure.
• You’ll need to pay closing costs between 2% and 5% of the home loan amount.

You should weigh the pros and cons before you choose cash out refinance for debt consolidation.

What are the benefits and risks of debt consolidation with HELOC?

Now, let’s examine the benefits and risks of using a HELOC for debt consolidation, starting with the benefits:

• As is the case with cash out refinance, you’re likely to have a significantly lower interest rate than you would with credit card debt.
• Your monthly payments will be streamlined and also smaller than what you have been paying.
• If you repay early, you’ll have the option to borrow again at a lower rate than you would get on a credit card.
• You’ll have the flexibility of making interest-only payments during the withdrawal period.

Here are some potential risks to consider:

• Most HELOCs have variable interest rates, which could increase your payments in the future.
• Your home is collateral, so you have the risk of losing your home if you fail to make payments in a timely manner.
• You’ll have to pay closing costs for your HELOC.
• There is a set draw period and when it ends, you’ll need to start repaying what you borrowed.

As you can see, many of the benefits and risks of refinance vs HELOC are the same. The biggest difference is that with a HELOC, you make interest payments only on what you borrow and are only required to make payments on principle once the withdrawal period ends and the repayment period begins.

How do you qualify for a HELOC or cash Out refinance?

Qualifying for a HELOC or cash out refinance isn’t as difficult as you might think. Here are the basic requirements:

1. Sufficient home equity. Many lenders want a combined loan to value ratio of 80% or less, which means you’ll need more than 20% equity to get approved. (At Addition Financial, we allow for a CLTV of up to 97% with a second mortgage that’s behind an Addition Financial first mortgage, but will only loan up to 80% with a first mortgage issued by another lender.) We suggest estimating your equity using an estimate from Zillow or Redfin, but keep in mind that any lending will be based on the appraisal ordered by the lender.
2. Debt-to-income ratio. Many lenders want to see a debt-to-income ratio (DTI) of 43% or lower for either a refinance or a HELOC. There may be some leeway but ultimately, you’ll need to earn enough money to show the lender that you can make your payments without difficulty.
3. Credit score. Some lenders have hard-and-fast rules regarding FICO scores, with the lowest allowable score typically being somewhere between 620 and 670. However, some lenders, including Addition Financial, prefer to underwrite looking at a borrower’s entire financial picture and may be able to work with you if your score is lower than the numbers we’ve listed.

These are the basic requirements for cash-out refinance or HELOC approval. You’ll also need to provide some documentation, including the following:

• Your most recent two months of pay stubs.
• Your most recent two years of W-2 forms.
• An asset statement.
• Two years of tax returns if you have self-employment income or income from tips, dividends, bonuses or any other non-employment income.

Your lender will review the numbers and determine whether you qualify for a cash-out refinance or HELOC.

Should I refinance or get a HELOC?

Now, let’s talk about how to decide whether to use cash out refinance or a HELOC to consolidate your debt.

Have a debt plan in place.

The first thing to do, and this applies whichever option you choose, is to put a debt plan in place. One of the biggest risks of using cash out refinance or a HELOC for debt consolidation is that you might be tempted to run up debt on your credit cards again after repaying your balances. 

Debt consolidation makes sense only if you have a solid plan to manage your spending and avoid running up debt. Failure to have one may lead to an increased debt load with higher interest rates back in the mix.

Decide if you need money for things other than debt consolidation.

The next thing to ask is if you need money for things other than debt consolidation. Cash out refinance will give you a lump sum of money that you can use to pay debts or for any other purpose, while a HELOC will give you access to a revolving line of credit you can use for debts and other purposes.

Some people who choose a HELOC for debt consolidation use their initial withdrawal to pay down debts and then use additional funds for other purposes. Keep in mind when choosing that the interest paid on money you use for home improvements may be tax deductible but if you use the funds for other purposes, including debt consolidation, the interest is not tax deductible.

Compare interest rates and payments.

The final step to decide on cash out refinance vs HELOC for debt consolidation is to compare interest rates and payments. It only makes sense to borrow against your home equity for debt consolidation if you can save a substantial amount on interest.

Any lender you approach will give you a loan estimate, which you can use to compare loan terms. Pay special attention to the interest rates, which are typically variable for a HELOC, and make sure you understand the terms of repayment.

Choosing cash out refinance vs HELOC for debt consolidation is mostly about reviewing your debt, current mortgage rates, and loan estimates to get a handle on what the best option is for your needs. From there, you can use the funds from your home equity to pay down your debt and get a handle on your finances.

Are you considering using home equity for debt consolidation? Addition Financial Credit Union can help! Click here to read about our HELOCs and begin the application process today.