FHA refi for debt consolidation? Exercise caution!

by Gina Pogol
February 4th, 2011

FHA’s underwriting guidelines make it clear that the agency is not a fan of debt consolidation financing. The FHA’s handbook states, “Cash-out refinances for debt consolidation represent considerable risk, especially if the borrowers have not had an attendant increase in income. Such transactions must be carefully evaluated.”

Why does FHA consider cash-out refis for debt consolidation so risky? The borrower could be lowering his or her total outgo by hundreds of dollars by replacing high-interest consumer debt with low interest mortgage debt. And the homeowner’s cash flow could be increased further if the mortgage interest is tax-deductible. So why the knock on debt consolidation?

The sad fact is that 75 percent of debtors who pay off their debts with consolidation loans turn right around and max out their credit lines again. This leaves them in worse trouble than before and at greater risk of default on mortgages and other debt. By taking the relatively easy option of wrapping their consumer debt into a home loan, the borrowers don’t get in the habit of living more frugally.

How can you be one of the 25 percent who successfully consolidate their debts and pay them off?

Pay off debt, don’t  accrue more

First, make sure that you are a good candidate for debt consolidation with a home mortgage. Once you execute that refinance, your unsecured debt, which could be discharged in a bankruptcy filing, becomes secured by your home. If you find yourself unable to make your mortgage payment, you lose your home. So if your health, job, or marriage are less than secure, you might want to keep bankruptcy as an option.

Second, decide if your debt problem is serious enough to warrant consolidation. If you just owe a few thousand and are making all of your payments on time, credit counseling and a debt management plan may be all that you need. If you could get free of your debt in three or four years, that might be a better solution — by rolling your debt into an FHA refinance, you’ll have it with you for 30 years! But if you refinance your home mortgage to a lower mortgage rate and payment, taking the money you save each month and putting it toward debt repayment may be all you need to get out of the woods.

Third, get some help from a non-profit credit counselor.  A good credit counselor will show you how to budget and save money.  You’ll probably be asked to close out or cut up your credit cards (keeping one for emergencies only). Being accountable to someone is a proven strategy, and you will need someone to keep you on the rails once you consolidate debt.

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