A cash-out refinance can lower the cost of what you owe, but behavior change is the only way to actually reduce debt.

A few weeks ago, my brother was driving through Utah and called me because he saw some billboards that he knew I would have a strong opinion about. He didn’t get a picture of the signs, but the messages basically said that you should “eliminate debt” with a “cash-out refinance”.

Even though he didn’t get a picture of those billboards, it only took a quick internet search for cash-out refinancing and I found a ton of ads promising to eliminate my debt by refinancing my mortgage.

Cash-out refinance advertisements
Internet ads promising to eliminate debt with a cash-out refinance.
Sources: rolandfinancialservices.com, rodneyanderson.com, h1mb.com, and lowermybills.com.

He was right. I do have a strong opinion:

A cash-out refinance does not eliminate your debt.
Only you can eliminate your own debt.

Only you can eliminate your own debt - Smokey Bear meme

Behavior Change Is The Only Way Out Of Debt

If you’ve read any of my other posts or my book, you know this is a judgement-free zone. It’s okay if you’ve got some debt. Most of us have more than we would like.

If you are at a point in your life where you would like to have less debt tomorrow than you have today, that’s great too. However, the absolute only way to do that is to change your behavior. There are no magic bullets, secret formulas, or special sauces that will do it for you.

That is not to say that refinancing your current debt (including credit cards, personal loans, car loans, and mortgages) shouldn’t be part of your strategy to get yourself debt-free. For most people, restructuring debt can be helpful, especially with today’s low interest rates. But, if restructuring debt is not accompanied by developing new habits, then you will quickly find yourself in the same situation all over again. Or worse.

Refinancing Does Not Pay Off Anything

Here is an example that I saw play out over and over again when I was a financial adviser:

A family has a variety of debt. Let’s say a $200,000 mortgage, two $15,000 car loans, a $10,000 personal loan, and $10,000 in credit card debt. That’s a total of $250,000 in debt.

Let’s also say that they bought their house five years ago for $250,000. Today, it would appraise for $350,000.

Now, if they wanted, they could restructure all of that debt. They could get a new mortgage for $250,000 and “pay off” all of their other debts.

I put “pay off” in quotes because that debt isn’t truly paid off. They still owe that money. They have just swapped one lender for another. Plus, getting a new mortgage is going to have some costs (application fee, origination fee, appraisal, title fees, etc.) It won’t be a lot as a percent of the total balance. But, it will likely be around 2%, or approximately $5,000, which they can include in the new loan.

So, now they have the original $250,000 in debt, plus another $5,000. So, not only have they not “eliminated” any debt, but they have added to what they owe (reducing their net worth, but you already knew that because you read this post).

I guess you could say that they took $55,000 of cash out of their home and “paid off” $50,000 of other debts, but even that doesn’t feel right to me. They haven’t “paid off” anything.

All That Newly Available Credit Is Tempting

But wait, there’s more!

Here’s the real kicker. If this family does not change their behavior, then they have set themselves up for their financial situation to get even worse.

For one reason or another (remember, no-judgement zone), this family has found themselves spending more than their income. If it was the other way around they would be accumulating cash instead of accumulating debt.

After the refinance, they only have one debt payment to manage. But they also have credit cards with at least $10,000 of newly available credit available. What’s to stop them from running up those credit cards again?

Cash-out refinancing without behavior change can be incredibly harmful to a family’s finances.

Lower Payments Means Staying In Debt Longer

Another big risk in this example is that the family is using the equity in their home to “pay off” their car loans.

Cars lose value every day. They lose value with every mile you drive. If you have a car loan and your car loses value faster than you pay off the debt, then you can get trapped owing more than the car is worth.

Most car loans last between four and six years.

But, by rolling their car loans into their mortgage, they are eliminating the requirement for that debt to be gone in the next few years.

Sure, refinancing a five-year loan into a 30-year loan will make the payments go down significantly. But, if you play that out, it would be like you bought the best selling car in 1989: a brand new Honda Accord… and made payments until 2019.

1989 Honda Accord SEi Coupe. Image Credit: Motortrend
1989 Honda Accord SEi Coupe. Image Credit: Motortrend

Gross. Absolutely not.

But, this family can avoid that problem by continuing to make the original payments after the refinance until the balance drops below what it was before the refinance.

For the family in the example, let’s say their mortgage interest rate was 6%, their car loans were both 6%, their personal loan interest rate was 9%, and their credit cards were at 15%. That would give them a combined monthly minimum payment of right around $2,200.

Assuming their new mortgage has an interest rate of 4%, then the new minimum payment would be just over $1,200.

In that case, I would recommend that they continue to pay $2,200 per month until the balance on the new loan drops below the old mortgage’s ending balance. If you remember that was $200,000.

By making an extra payment of about $1,000, they can get the balance down in about 4 years. Then, it will be like they have (actually) paid off their cars, credit cards, and personal loans.

At that point, I usually recommend a little trick. Open up a new savings account and put that extra payment into that account every month. The balance will quickly grow, and those funds can be used to pay cash whenever a car needs to be replaced. You can read more about the whole strategy in my post, here.

How To Use A Cash-Out Refinance To Your Advantage

A cash-out refinance rearranges your debt, which may allow you to pay less interest, and potentially eliminate your own debt faster. Properly used, a cash-out refinance can help you reduce the interest you pay on existing debt.

If you want a cash-out refinance to actually reduce your debt, here are three rules that will help you make the strategy work:

  • The new interest rate must be significantly lower than the old interest rates;
  • Continue making the same payments you were making before the refinance, even if the minimum required payment decreased; and,
  • Change your spending habits so that you do not take on new credit card debt or personal loans.

Consolidating high-interest debt into lower-interest debt is a vital part of a debt reduction strategy. But, it only works if you don’t go back into high-interest debt.

Final Thoughts

If you have read any of my other posts or my book, then you know this is always a no-judgement zone. I’m not here to question your past choices. But, if you are unhappy with the level of debt you have right now and you wish you had less of it, then the hard truth is that there is no magic product out there that will eliminate your debt for you.

The only way to eliminate your debt is through discipline and behavior change.

I hope this has been helpful! I welcome your comments with your thoughts and questions.

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