Are you trying to refinance your home but have been told by lenders that your debt-to-income ratio is too high for approval?
In some cases, you may be able to use a cash-out refinance to pay down your debts as part of the closing process to help you qualify. This strategy can also help to reduce the interest rate you’re quoted.
We’ll explain how lenders evaluate debt, how paying off debt at closing works, and why using a cash-out refinance to consolidate debt may be a smart move.
Yes. Many lenders allow certain debts to be paid off with cash-out refinance proceeds at closing. When structured properly, those debts may be excluded from your debt-to-income ratio calculations, potentially helping you qualify for a refinance. In fact, debt consolidation is one of the top 3 refinancing intents!
How Lenders Calculate Your Debt-to-Income Ratio for a Refinance
Lenders use your debt-to-income (DTI) ratio as a metric for assessing your ability to repay a loan. Your DTI is calculated by dividing your monthly debt obligations by your monthly qualifying income.
This can include an assortment of debts, such as:
- Mortgage costs
- Car loans
- Credit card minimums
- Personal loans
- Student loans
- Alimony and child support payments
It does not, however, include expenses such as utility bills, insurance premiums, gym memberships, or your morning coffee fix.
Example: You have a qualifying monthly income of $6,000. You’re trying to refinance into a mortgage with $1,900 monthly payments. You also have a $400 car payment and a minimum credit card payment of $300 per month, for a total of $2,600 in ongoing debt obligations.
Here, your DTI ratio is 43.3%, which is generally within the acceptable range for refinance approval.
Can You Exclude Debt From DTI if It’s Paid off at Closing?
But what if your ratio is higher? Revisiting the previous example, let’s say you have $3,600 in monthly debt obligations on a $6,000 income. This equates to a DTI ratio of 60%, which very few lenders will accept. With a DTI that high, refinancing your home will be a challenge.
In many cases, though, you can exclude debts from your debt-to-income ratio by paying them off or down at closing. However, this process must be structured correctly, which, with refinances, typically involves your closing agent (often a title company or attorney) using the proceeds from your mortgage to settle these debt obligations on your behalf.
Keep in mind that every lender has different policies, and while it’s not uncommon to use a cash-out refinance to pay off debt at closing, not every lender allows it. Even for those that do, you’ll likely find varying guidelines regarding what types of debts they’ll allow to be excluded.
How Paying Off Debt at Closing Works
How does the process of paying off debt at closing work? Here are the steps that you can generally expect.
1. Discussing Your Options With Your Lender
Is paying off debt at closing a practical solution for you? Do you have enough built-up equity? Which are the best debts to pay off? These are the questions you’ll discuss with your lender.
Many loan programs allow installment debt, such as car loans, to have 10 or fewer remaining payments excluded from DTI calculations, though lender guidelines vary. This means you may be able to reduce a debt rather than pay it off altogether and still improve your DTI.
2. Submitting Proper Documentation About Your Debts
After working with your lender to identify the debts you’ll pay off as part of the closing process, you’ll need to gather and submit documentation regarding those accounts, which will usually include:
- The creditor’s name and payment mailing address
- Your account number
- A statement showing the current payoff amount
3. Debt Is Removed From Your DTI, and Your Loan Goes Into Underwriting
At this point, your DTI is recalculated, and your loan goes into underwriting. Here, underwriters will take a closer look at your risk profile based on the reduced DTI, on the condition that the loan proceeds will be used to pay off the specified debts.
4. Your Lender Coordinates Payoff With the Closing Agent
While the underwriters are evaluating your file, your lender will coordinate with the closing agent to pay off the debts as part of the closing settlement. When your loan gets underwriting approval, you’ll proceed to closing and finalize your cash-out refinance with your debts paid from the proceeds.
Note: In most cases, checks will be mailed by your settlement agent to satisfy your debts. This process isn’t instant, so it’s recommended that you still make your regularly scheduled payment for the month if the due date is approaching to avoid potential late penalties.
Example: Using a Debt Payoff to Qualify
Let’s take a quick look at how using a cash-out refinance to pay off debt at closing could work in practice:
In this example scenario, the prospective borrower has a monthly qualifying income of $6,000 and $3,000 in ongoing debt obligations. With their DTI of 50%, they are unable to qualify for the refinance they’re applying for.
However, their lender agrees to allow them to use the proceeds from their loan to pay off $30,000 in credit card debt and remove the associated $1,000 monthly minimum payment from their calculations.
This reduces their debt obligations by a third, down to just $2,000. With their income at $6,000, their new debt-to-income ratio is 33.3%, which allows them to qualify for the refinance and lowers their interest rate thanks to the lower DTI.
Should You Pay Off Debt Before or at Closing?
Is it better to pay off your debt before or at closing? Both options have their pros and cons, so it’s important to evaluate the tradeoffs to determine which strategy is the best fit for you.
Paying Debt Off Before Closing
Paying off your debts before closing, especially if you do so before beginning the loan application process, can often lead to a much smoother, cleaner underwriting experience. This can speed up the closing process, reduce the amount of documentation you’ll need, and increase your chances of approval.
Reducing revolving debt, such as credit card debt, in advance can also improve your credit utilization and increase your credit score, which could further improve your chances of refinancing approval and securing a better rate.
However, this will require you to have access to the funds to satisfy your debts without tapping into your home equity. That isn’t always a realistic option for every borrower.
Plus, it will take time for your debt accounts to be updated on your credit report. Oftentimes, this can take weeks to months.
If you’re about to apply for a refinance or have already begun your application, your lender will need to obtain verification that your debts have indeed been settled or reduced to ten or fewer remaining payments. In some cases, it may be simpler to let your lender coordinate the payments as part of your closing.
Paying Debt Off at Closing
For most borrowers, the primary motivation for paying off debt at closing is that they can use the loan proceeds rather than having to have the funds up front. This makes the process far more accessible, especially for homeowners currently struggling with their finances.
But as we mentioned, doing so can often complicate the loan approval process compared to coming in with your debts already reduced.
Another thing to keep in mind is that using a cash-out refinance to satisfy debt will increase your total loan balance, and you’ll be paying long-term interest on the additional amount.
Using a Cash-Out Refinance for Debt Consolidation
Loan qualification aside, using a cash-out refinance for the purpose of debt consolidation can be a savvy financial decision, especially if you’re consolidating other high-interest debts like credit card payments.
Here, you’re effectively combining multiple debts into one single payment, your mortgage. Often, this will lead to lower overall monthly costs, which can improve your cash flow, sometimes significantly.
However, as with most aspects of finance, this is a tradeoff. Mortgages, and cash-out refinances in particular, often have a 30-year repayment term. This likely means stretching your debt repayment over a longer period, which, even at a reduced interest rate, can still wind up costing you more in interest over the life of the loan.
Everyone’s individual financial situation is different, making it crucial that you compare your choices and work with an experienced lending professional who can explain how each option could impact you both in the short term and over the long run.
FAQs About Debt Payoff
Still wondering whether paying off your debt at closing is the right choice for you? Here are straightforward answers to some of the most frequently asked questions about debt payoff.
Can I Use a Cash-Out Refinance to Pay off Credit Cards?
Yes, in fact, this is one of the most common reasons for homeowners to apply for a cash-out refinance. The Federal Reserve’s most recent data shows that the average credit card interest rate is 21%, with figures from other sources even higher. Refinancing this debt into a mortgage with a far lower rate can potentially slash your monthly expenses.
Will Paying off Debt Improve My Chances of Approval?
Paying off debt can improve your chances of mortgage approval, sometimes substantially, by lowering your overall debt-to-income ratio, which lenders use to assess your ability to repay a loan. By reducing your DTI, not only are you more likely to be approved, but you’re also more likely to qualify for a lower interest rate.
Does Debt Need to Be Paid Off Before Closing?
No, debt does not necessarily need to be paid off before closing. In some cases, depending on the lender’s guidelines and your individual situation, you may be able to wrap your debt payoff into the refinance process, with the debts paid at closing and excluded from your DTI calculations.
Is It Smart to Roll Debt Into a Mortgage?
Rolling other debts, especially those with higher interest rates, into your mortgage can be a smart move, but it depends on your unique financial situation and long-term goals. While consolidating other debts into a mortgage can reduce your overall monthly payments, it often means repaying those debts over a longer term, which can increase lifetime interest costs.
Paying Off Debt at Closing With a Cash-Out Refinance
If debt is keeping you from refinancing your home, you may still be able to get approved by using a cash-out refinance to pay off debt as part of the closing process. This can allow lenders to calculate your debt-to-income ratio based on the reduced monthly obligations, potentially making it easier to qualify for a refinance and lowering the interest rate quoted on your loan.
