If you have more than mortgage debt, you have “bad debt.” Credit cards, personal loans, or any other debt that doesn’t have collateral is debt that eats away at your savings. Maybe you lived outside of your means or you just relied on the available credit balances. Now that you have balances staring you in the face, it’s time to pay them off.
One debt consolidation method is to combine the not-so-good debt with the good debt.
Do You Have Equity in Your Home?
You’ll need equity in your home in order to make this process happen. A home equity loan or line of credit is the most common way to consolidate debt. However, you may be eligible for a cash-out 1st mortgage refinance too.
Before you proceed, figure out how much equity you have. You can talk to your lender to get an automatic valuation of your home. You can also use an online source, such as Zillow. This will let you know how much your home is worth (an approximate value). Next, you need to know how much loan you still have outstanding.
Once you have these two figures, you can figure out your current LTV. Let’s say your home is worth $350,000 and you have $250,000 in outstanding loans. You’d do the following calculation:
$250,000/$350,000 = 71.4%
You’ll find loans that allow a maximum 80% LTV as well as those, such as FHA cash-out loans that go up to 95% LTVs.
Let’s say you applied for a HELOC with a maximum 80% LTV. That means you’d have $30,000 available in a home equity loan. If you used the FHA cash out refinance, you could take as much as $82,500 out.
Consolidating the Bad Debt
Once you figure out how much equity you have in your home, you can decide how to consolidate the bad debt.
If you have a good interest rate on your first mortgage already, you may not want to touch it. Unless you can secure the same or lower rate, a HELOC or home equity loan might be a better option. This way you leave the 1st mortgage untouched. You then take out a 2nd separate loan that pays off your debts.
How the lender proceeds depends on the situation. If paying off the bad debt is a condition of your approval, the lender will pay your creditors directly. If your debt ratio is okay, the lender may give you access to the funds and let you pay the debts off yourself.
If you don’t have a good interest rate right now, you may want to refinance your first mortgage. This is a cash-out refinance. This allows you to wrap your credit card or personal debt in with your good debt, your mortgage.
In a cash-out refinance, you pay off your first mortgage at the closing. The lender then opens a new mortgage for you. The portion that paid of your original mortgage is used. You can then use the remaining funds to pay off your other debt. Usually, your lender will pay the debts off for you.
Reaping the Savings of Paying off Bad Debt
When you pay off bad debt, you save money. Credit cards and personal debt usually carry fairly high interest rates. Even if you are diligent about your payments, it’s hard to dig your way out of that debt.
Mortgage debt, on the other hand, usually has much lower rates. Even if you take a cash-out refinance, which has higher rates than a standard 1st mortgage, you’ll likely pay less interest.
Even though you’ll be paying the debts over a longer period, the lower interest can save you money. If you can afford to make larger payments, that’s the best-case scenario. This way you pay the principal down and pay even less interest. A good way to knock down your loan’s principal is to make one extra mortgage payment per year. This can knock several years off the life of your loan.
The Risk of Increasing Your Good Debt
Of course, with the good, always comes the bad. First, you make unsecured debt suddenly secured. If you default on your mortgage or mortgages, you put your home at risk. Defaulting too far on the loan could cause you to go into foreclosure.
Even if you can afford the payments and don’t default, you will pay more for the debt. Your credit card debt didn’t have a term. You could pay it off at any time. When you wrap it into your mortgage debt, you stretch the payments out for a longer term. Let’s say you took at a 30-year cash-out first mortgage. You now owe the debt for those 30 years. This means paying 30 years of interest, unless you pay the debt off early.
Finally, clearing up personal debts could leave you open to get into debt even further. Once you pay off your credit cards, they are valuable for use again. It’s not recommended that you close each of them, though, as this can hurt your credit score. It’s best to leave them open but untouched. If you were to rack the debts up again, you’d end up worse than how you started before you consolidated the debt.
In the end, you come out the winner. You just have to be careful with how you proceed after you pay off your debt. Get yourself into a routine where you only buy what you can afford. Using credit cards or taking out personal loans just puts you into debt. It allows you to leave outside of your means. If you don’t pay the debt off right away, it ends up costing you money.
Consolidating your bad debt with good debt is a great way to get a handle on your finances and give yourself a fresh start!