From 20% to 7%: How a Cash-Out Refinance Can Crush Your Credit Card Debt and Save You Thousands

Introduction

Sarah and Tom were drowning in credit card debt. Between unexpected medical bills, necessary home repairs, and some ill-timed vacations, their credit card balances had ballooned to over $30,000. With interest rates hovering around 20%, their monthly minimum payments barely made a dent in the balance, and the stress was overwhelming. But one day, while discussing their finances with a friend, they heard about a potential solution: a cash-out refinance on their home. Could refinancing their mortgage actually help them get out of high-interest debt? And if so, when would it make sense?

In this post, we'll explore the differences between credit card debt rates and mortgage rates, explain how refinancing can help you tackle debt, and discuss when a cash-out refinance might be the right move for your financial health.

Understanding Credit Card vs. Mortgage Rates

Credit Card Interest Rates

Credit card interest rates are typically among the highest rates consumers face. According to the Federal Reserve, the average interest rate for credit cards in the U.S. was around 20.68% in 2023. Some cards, especially those marketed to individuals with poor or limited credit history, can have rates as high as 25-30%. High-interest rates make it challenging for borrowers to pay down their debt, especially if they’re only able to make minimum payments.

Mortgage Interest Rates

Mortgage rates, on the other hand, tend to be much lower. In recent years, they’ve fluctuated due to economic factors, but as of early 2024, the average mortgage rate for a 30-year fixed mortgage in the U.S. was around 7.2%. Although this is relatively high compared to the mortgage rates of the early 2020s, it's still far lower than most credit card rates.

The stark difference between credit card interest rates and mortgage interest rates is what makes a cash-out refinance so appealing for those looking to consolidate and pay down debt. A cash-out refinance allows homeowners to leverage their home equity to access cash, which they can then use to pay off high-interest debt, effectively consolidating their liabilities at a lower interest rate.

What is a Cash-Out Refinance?

A cash-out refinance replaces your existing mortgage with a new mortgage that has a higher balance than what you currently owe. The difference between your current mortgage balance and the new loan amount is given to you as cash. For example, if you owe $200,000 on your mortgage but your home is valued at $400,000, you may be able to refinance for $250,000 and take the $50,000 difference in cash.

This option can be attractive for people who have built up significant equity in their homes and are facing high-interest debt from credit cards or other sources. By refinancing at a lower interest rate than what they're paying on their credit card debt, they can save money on interest and pay off debt faster.

Reasons to Use a Cash-Out Refinance to Pay Off Debt

1. Lower Interest Rates
2. A cash-out refinance can reduce the interest rate you’re paying on your debt. For instance, if you’re paying 20% interest on credit cards, replacing that debt with a 7% mortgage rate can lead to substantial savings over time.
3. Simplified Payments
4. By consolidating debt through a cash-out refinance, you’re left with just one monthly mortgage payment rather than multiple credit card payments. This can simplify budgeting and make it easier to stay on top of your finances.
5. Improved Credit Score
6. High credit card balances can harm your credit score, especially if you’re using a large portion of your available credit. Paying off credit cards can lower your credit utilization ratio, which is a significant factor in your credit score calculation. With an improved credit score, you may have access to better rates and financial products in the future.
7. Potential Tax Benefits
8. Mortgage interest is often tax-deductible, whereas credit card interest is not. Although tax laws have changed and limitations apply, some homeowners may still benefit from deductions on mortgage interest payments. Consult a tax advisor to understand how a cash-out refinance could affect your specific tax situation.

When Should You Consider a Cash-Out Refinance?

A cash-out refinance isn’t for everyone, and timing and financial readiness are crucial. Here’s when it might make sense:

1. Sufficient Home Equity
2. Lenders typically require you to maintain at least 20% equity in your home after the cash-out refinance. If your home is worth $400,000, you would likely need at least $80,000 in equity after refinancing, so you could access up to $320,000.
3. High-Interest Credit Card Debt
4. If your credit card debt interest rate is significantly higher than your mortgage rate (e.g., 20% vs. 7%), it may be financially advantageous to use a cash-out refinance to pay off the credit card balance. This is especially true if you’re struggling to make progress with just minimum payments.
5. A Stable Financial Situation
6. Refinancing converts unsecured debt (like credit card debt) into secured debt, meaning your home is now collateral for the loan. If you lose your job or face unexpected financial difficulties, you risk foreclosure if you can’t keep up with mortgage payments. A cash-out refinance should only be considered if you have a stable income and a clear repayment plan.
7. Long-Term Stay in the Home
8. Refinancing involves closing costs, which are typically 2-5% of the loan amount. To offset these costs, it’s usually best to stay in your home for several years after refinancing. If you’re planning to move soon, the savings might not outweigh the upfront expenses.
9. Need for a Lower Monthly Payment
10. If consolidating credit card debt helps you reduce your total monthly debt payments, a cash-out refinance can provide breathing room in your budget. Just be cautious not to accumulate new credit card debt, as this would put you in a worse financial situation than before.

How Much Debt Should You Have to Consider a Cash-Out Refinance?

The amount of debt that warrants a cash-out refinance varies depending on individual circumstances, but here are some guidelines:

1. Debt Amount: If you have high-interest debt above $10,000, especially with interest rates over 15%, a cash-out refinance could offer significant savings.
2. Monthly Cash Flow: Consider the impact on your monthly cash flow. If you’re using more than 20% of your monthly income to service credit card debt, consolidating that debt into a lower-interest mortgage can alleviate pressure on your budget.
3. Long-Term Plan: The ideal scenario is to use the refinance to eliminate debt and avoid taking on new high-interest debt. It’s important to commit to a financial strategy that prevents the need for future refinancing to cover additional credit card debt.

Potential Risks and Drawbacks

Before jumping into a cash-out refinance, consider these risks:

1. Increased Mortgage Length: Refinancing may extend your mortgage term, meaning you’ll be paying off debt over a longer period, which can add up in interest costs over time.
2. Closing Costs: The closing costs for a refinance are similar to those for an original mortgage and can be a significant expense. Make sure the interest savings are worth the upfront cost.
3. Risk of Foreclosure: By converting unsecured debt to a secured debt (your mortgage), you risk losing your home if you can’t make the payments. This is a big risk, and should not be overlooked.

Final Thoughts

For homeowners facing high-interest credit card debt, a cash-out refinance can be a valuable tool for debt consolidation. By leveraging the equity in your home, you can pay off credit cards at a much lower interest rate, simplifying payments and potentially improving your credit score. However, it’s essential to carefully consider your financial stability, long-term plans, and commitment to avoiding future high-interest debt.

If you’re thinking about a cash-out refinance, consult with a financial advisor or mortgage broker to evaluate your options, as the decision should be tailored to your unique situation. When used strategically, a cash-out refinance can be a powerful way to regain control of your finances and work toward financial freedom.

ONE MORE THING. 

If you are not ready to proceed with a cash out refinance, take the tiem to statt a budget first. We use Quicken for this and its been a fantastic wayo to manage all expenses. Click on the link below.