This is a guest post by Monique Rowe. If you want to guest post on this blog, check out the guidelines here.
Everyone seems to be seeking debt relief these days. No matter the source, debt haunts them like a ghost. It steals a portion of their income. Creditors and debt collection agencies are attracted to debt like vultures. Of course, there are legitimate reasons why collection agencies and creditors are interested in debt. Creditors want their money back, and debt collection agencies are trying to pay their salaries. Owing large debts is still unpleasant for consumers, regardless of the bad decisions they probably made when they went into debt.
The preponderance of debt has led to intense interest in debt consolidation. This controversial practice involves using additional debt to consolidate multiple debts into a single debt. Presumably, this makes the new debt easier to pay off. Aggregate spending on debt is reduced, and the monthly payments may be lower, freeing up more income. Debt consolidation is dangerous because taking on more debt to repay old debts may become an additional burden. Borrowers with irresponsible spending habits are liable to simply fall back into debt even as they pay off old debts.
Obviously spending habits have to be controlled when using debt consolidation. Setting up a budget, perhaps through a credit counseling process, in combination with taking out a debt consolidation loan is optimum. The portion of income that makes payments on principal and interest charges is reduced. This gives the borrower an opportunity to build up savings. Consolidating debt is done through multiple methods: home equity loans, home equity lines of credit and cash-out refinancing. Cash-out refinancing has become popular; here are its risks and benefits.
How cash-out refinancing works
A borrower refinances his existing mortgage into a larger loan. A borrower with a mortgage worth $150.000 on a home worth $215.000 has equity totaling $65.000. If he takes out a new mortgage for $215.000, he can pocket the $65.000 difference between the two. He cashes out his equity in exchange for a larger loan. Cash-out refinancing replaces an existing mortgage. It does not add a second mortgage, as does a home equity loan.
The most obvious risk is connecting the borrower’s home with his ability to repay the consolidation loan. If he does not reign in his spending, and the borrower defaults, he could lose his home. This leaves him in worse shape than if he did not use cash-out refinancing to repay his debts.
Another risk is paying for a short-term expense over a long-term period. This is why borrowers who use cash-out refinancing for discretionary spending always feel buyer’s remorse. They are essentially paying for the same thing for 15 or even 30 more years. Since debt consolidation may be a long-term expense, cash-out refinancing can make sense if the debt load is large enough or the interest rates are high enough.
Perhaps the biggest risk of all is losing out on the equity when the home is eventually sold. Cash-out refinancing, in today’s environment of falling home prices, increases the risk of negative equity. The mortgage balance is greater than the home’s price. Negative equity means the borrower is not going anywhere. He is prohibited from selling his house unless he can prove to the lender that he can make up the difference.
The main benefit of cash-out refinancing is lower monthly payments. This is due to a lower interest rate and not to a lower balance. Depending on various factors, such as credit utilization and the borrower’s current credit rating, the interest may be much lower. Moving high-interest debt like credit card debt to a home equity loan can lower the interest rate. Not only do interest rates on credit cards tend to be higher, but multiple rates combined translate into one extremely high rate.
Another advantage is the tax break the borrower gets by deducting the interest on the new mortgage from his taxable income. Depending on the size of the mortgage, this can be quite substantial. Lower taxable income means less taxes, and that can ease the burden of the mortgage considerably.
The balances on all of the borrower’s credit cards are wiped clean. This, of course, is a golden opportunity to get right back into debt, with the possibility of a lost home to boot. Cash-out refinancing for debt consolidation is a viable strategy, but only if the borrower uses the opportunity responsibly and wisely.