Debt Consolidation Mortgage: Should I Get One?
A debt consolidation mortgage is typically a type of mortgage refinance that gives you access to additional funds that you can use to pay off outstanding debts. You’re likely to save money by consolidating all of your debts into a single loan, as mortgage rates are more affordable than the interest rate on, say, a credit card or personal loan.
But before you decide to consolidate your debt using a mortgage, it’s important to understand your loan options and review their pros and cons.
What is a debt consolidation mortgage?
A debt consolidation mortgage is when you take out a new home loan and use the extra cash it provides to pay off auto loans, student loans, credit cards or other debt. If you choose a refinance, the loan will also replace your current mortgage; if you choose a second mortgage, it won’t. But, no matter which type you choose, the loan is secured by your home equity.
In many cases, you’ll be left with a single loan payment at a lower interest rate, which can greatly simplify your finances and save you thousands of dollars in interest charges.
However, because you’re converting nonmortgage debts into mortgage debt, you’re putting your house at increased risk. If you fail to keep up with your debt consolidation mortgage payments, you could lose your home to foreclosure. The same isn’t true if you default on nonmortgage debt like auto loans, credit cards, or student loans.
Types of debt consolidation mortgages
- Cash-out refinances. A cash-out refinance is a mortgage with a loan amount that’s large enough to cover what you owe on your current mortgage, plus a lump sum to pay off debts. This is the most common type of debt consolidation mortgage.
- Home equity loans. A home equity loan also provides cash that can be used to consolidate your debt, but it doesn’t replace your current mortgage. It’s secured by your home equity and sits second in line to be repaid if your home ever goes into foreclosure.
- Home equity lines of credit (HELOC). Just like a home equity loan, a HELOC is a second mortgage that’s secured by your home. Instead of a one-time payout, though, a HELOC gives you access to a credit line that you can use and reuse up to a certain limit. HELOCs come with variable interest rates and many give you an interest-only payment option during a set time called the draw period.
- Reverse mortgages. Unlike a regular “forward” mortgage, you don’t make a monthly payment on a reverse mortgage. Instead, you’ll receive a payout secured by your home equity. The loan won’t usually need to be repaid until you move out of the home or die.
You could have two mortgage payments
If you choose a home equity loan or HELOC, you’ll have two mortgage payments to keep up with each month. Juggling two separate home loans with different payment amounts, interest rates and payoff schedules can be a downside if you’re looking to consolidate your debts and simplify your finances.
How does a debt consolidation mortgage work?
A debt consolidation mortgage usually works a lot like a cash-out refinance, and may even be called a “debt consolidation refinance.” The main difference, however, is that you won’t receive the lump sum of cash and then manually pay your creditors. Instead, the credit accounts are paid off through the closing process.
The loan is secured by your home equity, and lenders commonly require you to have at least 20% equity.
Lenders will vet your finances to confirm you can afford the new mortgage payment. You’ll also need a home appraisal to confirm you have enough equity — most loan programs only let you borrow up to 80% of your home’s value.
Example: How a debt consolidation mortgage can save you money
Let’s explore how much you’d save by taking out a $247,000 debt consolidation mortgage to pay off $47,000 worth of credit card and auto loan debt.
For the sake of our example, let’s say you’re carrying the following debts:
- $10,000 in credit card debt with a 3% minimum monthly payment. That’s a $300 monthly payment.
- $37,000 in auto loan debt at a 7.53% interest rate. That’s a $670 monthly payment.
- $200,000 on a home you paid $400,000 for. Your monthly mortgage payment is $2,100.
Here’s a breakdown of how a debt consolidation mortgage would change your financial picture:
| Current principal and interest mortgage payment | $2,100 |
| Current debt payments | $970 |
| Total monthly debt and mortgage payments | $3,070 |
| New principal and interest mortgage payment | $1,610 |
| Monthly savings | $1,460 |
In this example, you save $1,460 per month with the debt consolidation mortgage. However, you’ll pay more in mortgage interest over the life of the loan. Note also that current tax laws don’t allow you to deduct mortgage interest on the portion of your loan used to pay off nonmortgage debt.
Pros and cons of a debt consolidation mortgage
| Pros | Cons |
|---|---|
Simplicity. You can simplify your finances by reducing the number of debts and debt payments you need to manage. Flexibility. You’ll have more room in your budget, which can help you avoid using credit accounts in the future. Savings. You can use the savings to pursue other goals. You might build up your emergency fund or apply the savings to your principal to pay down the balance faster. Credit bump. Your credit scores may improve as a result of carrying less revolving debt. | Increased mortgage debt. Your monthly mortgage payment may be higher, due to the larger loan amount. Interest costs. You’ll pay more in mortgage interest over the life of the loan and typically pay a higher interest rate than you would on other refinance types. Risk to your home. You could lose your home to foreclosure if you can’t afford the new mortgage payments. Loan costs. You’ll usually pay between 2% and 6% of your loan amount toward closing costs. Tax limitations. You can't deduct any mortgage interest that’s tied to your debt payoff. |
Debt consolidation mortgage loan programs
- Conventional cash-out refinance. If you have a credit score above 620 and a solid employment history and income, you can borrow up to 80% of your home’s value with a conventional cash-out refinance.
- An added bonus: Because you can’t borrow more than 80% of your home’s value, you won’t pay monthly mortgage insurance (mortgage insurance protects your lender if you default on your loan).
- FHA cash-out refinance. Borrowers with scores as low as 500 may qualify for a debt consolidation mortgage backed by the Federal Housing Administration (FHA). Like the conventional cash-out refinance, an FHA cash-out refinance caps you at borrowing 80% of your home’s value and requires proof of income and a home appraisal.
- One big drawback: You’ll pay two types of FHA mortgage insurance, including an upfront lump-sum premium of 1.75% of your loan amount. The second charge is an annual mortgage insurance premium that ranges between 0.15% and 0.75% of your loan amount, which is divided by 12 and added to your monthly mortgage payment.
- VA cash-out refinance. Eligible military borrowers may be able to borrow up to 90% of their home’s value with a loan guaranteed by the U.S. Department of Veterans Affairs (VA).
- FYI: Although there’s no mortgage insurance requirement, VA borrowers may have to pay a VA funding fee between 2.15% and 3.30% of the loan amount, depending on whether they’ve used their benefits before.
- Home equity loans and HELOCs. There are no government-backed second mortgages — so if you’re interested in either of these options, you’ll need to seek out conventional loan lenders. You’ll typically need a minimum 620 credit score and at least 15% home equity to qualify.
- FHA reverse mortgage. If you’re 62 years or older with a lot of equity in your home (usually 50% or more), you may qualify for a home equity conversion mortgage (HECM), more commonly known as a “reverse mortgage.” Unlike a regular mortgage, your loan balance grows each month, meaning you lose equity in your home over time.
Making the decision: Is a debt consolidation mortgage right for me?
A debt consolidation mortgage is a good idea if you’ll save more money overall than what it costs you to take out the loan. Add up the interest and closing costs you’ll pay on the new mortgage, and compare that number to the interest you’d pay if you continued paying your existing nonmortgage debts and your current mortgage separately.
Alternatives to debt consolidation mortgages
Personal loans
A personal loan allows you to take out a smaller amount, typically at a higher interest rate than debt consolidation mortgages. However, because the loan isn’t secured by your home, you don’t have to worry about losing your home if you miss payments.
Debt management plans
Credit counseling organizations offer these types of programs to help people consolidate unsecured debt. There may be initial setup fees, and it could take longer to be approved because your credit counselor will need to negotiate with your creditors on what payments they’ll accept. A debt management plan may be a good option if you don’t qualify for a debt consolidation mortgage due to low credit scores.