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Debt consolidation by refinancing your home loan

Publication Date: Monday, 17 July 2023
This article originally appeared in finder

How does refinancing a home loan let you consolidate debts?

Refinancing a home loan for debt consolidation means taking out a bigger mortgage to pay off other debts. It effectively means combining multiple debts into a single loan.

Because home loans have lower interest rates, this can be a cost-effective way to consolidate higher-interest debts like credit card or personal loan debt. But combining short-term debts into a 30-year mortgage may cost you much more interest in the long run.

Borrowers looking to consolidate debts by refinancing need to balance the risks and benefits and make a plan to pay off the combined debt faster (while avoiding getting further into debt).

The benefits and risks of refinancing a home loan for debt consolidation

The benefits

“Because mortgages are backed by an asset, the interest rate on a home loan is almost always lower than the interest rates on other debts,” says Brighten Home Loans National Sales Manager Chris Meaker.

This can make debt consolidation via a home loan cheaper, at least in terms of monthly repayments. Rates on credit cards can be several times higher than a home loan’s.

“Refinancing a mortgage to consolidate debt can have a range of benefits on top of lower overall borrowing costs,” says Meaker. “It’s easier to look after just one loan account, for example, instead of many — it means just one regular repayment instead of several, making budgeting simpler.”

The risks

Debt consolidation doesn’t mean your other debts have vanished. Instead, you’ve combined several shorter term debts into your home loan. This “often extends the payment period of the credit card or personal loan,” says Meaker.

“While this means lower interest rates and lower monthly repayments, it can also mean an increase in the overall cost of the debt over the lifetime of the loan.”

Example: Jenny looks to consolidate her debts

Jenny has a $400,000 home loan with a rate of 5.50% and a 30-year loan term. Her monthly repayments are $2,272.

She also has a $10,000 personal loan debt with a 3-year loan term and a 20% interest rate. This costs her $372 a month.

Her total costs = $2,644.

Jenny is struggling with these repayments.

If she can refinance to a new 30-year home loan with the same rate of 5.50%, her debt will now be $410,000. But her monthly repayments will be smaller, at just $2,328.

Now she’s saving $316 a month.

This has solved Jenny’s immediate problem of higher monthly repayments. But the problem is that Jenny has taken a $10,000 debt that was meant to last 3 years and stretched it out to 30 years.

Over that time, she’ll end up paying another $10,000 just in interest on this debt. With her original personal loan, she would have only paid around $3,300 in interest.

But Jenny’s new home loan lets her make extra repayments. This means Jenny can offset the higher interest charges by paying off a little more each month than her minimum repayment. If she paid $50 extra per month she’d end up saving over $25,000 in interest.

When you should really avoid refinancing to consolidate debt

Getting into more debt in order to pay off other debts is obviously risky behaviour. It’s only worth considering if the consolidation makes your repayments more manageable and you’re confident you can handle the repayments in future.

“Debt consolidation doesn’t address the possibly risky behaviour that led to the debt in the first place,” says Meaker. He suggests borrowers who consolidate debts should not take out new credit cards or loans “avoid falling into a debt spiral.”

Here are some signs that you may be caught in bad debt:

  • You’re borrowing money from one source to pay another.
  • You pay off your credit card only to start making more purchases, getting into debt again.
  • You only make the minimum repayments on your credit card.
  • You have more than 3 different types of debt, including unpaid bills.

5 Tips for paying off credit card debt without refinancing

1. Consider a balance transfer. With a balance transfer you can move your credit card debts to a new credit card which offers a period of low or 0% interest. This gives you time to pay off the debt.

2. Write up a budget. Learning exactly how much money you have to spend each week, month or year is a great way to know how much you can afford to put towards shrinking your credit card debt.

3. Pay the highest interest debt first. If you have more than 1 credit card, put more cash towards paying off the higher interest card first.

4. Pay more than the minimum repayment. Paying the minimum repayment will keep you out of trouble with your card provider, but could see your debt paid off at a snail’s pace, meaning you pay a huge amount of interest.

5. Pay more than the minimum repayment. Paying the minimum repayment will keep you out of trouble with your card provider, but could see your debt paid off at a snail’s pace, meaning you pay a huge amount of interest.

7 steps to refinancing your home loan to consolidate your debts

1. Review all your debts. Start by setting out all your debts, including the amounts owed, the interest rates and how much you are making each month in repayments.

2. Check your equity. The equity in your home is the current value of the property minus the amount remaining on your home loan. If your home is worth $800,000 and there’s $350,000 left on your home loan, then you have $450,000 in equity. You need to have at least enough equity to cover your debts in order to refinance and bring your debts together.

3. Compare loans. Once you decide to refinance, look around for a loan with a lower interest rate and features that suit your needs. You can also try to refinance with your current lender, which can save you some time.

4. Crunch the numbers. When you’ve found a loan that looks good, use a loan repayment calculator. Add together the total home loan amount and all your other debts, then work out how much the monthly repayments are. This number should be lower than all the combined debt repayments you’re currently making.

5. Apply for the new loan. Get all your mortgage paperwork together and apply for the new loan. If you have enough equity this should be easy enough, but with multiple debts the lender may be stricter on your application. This is why it’s a good idea to speak to a mortgage broker before you start applying.

6. Focus on paying off the new home loan. Now that you have a single, long-term debt, focus on paying it off. Make extra repayments if the loan allows it. If the home loan has an offset account, build up some savings in it.

7. Avoid getting into further debt. If you can avoid taking out another personal loan or credit card you can focus on your single debt and avoid making past mistakes.