Debt restructuring with lackluster credit

Dear Dr. Don,
My wife and I are currently in the eighth year of a 30-year fixed-rate mortgage with a 6.6 percent interest rate. It was a no-documentation loan taken out in 2005 because of the self-employment status of my wife.

We now owe $170,000 on a house recently appraised for $250,000. Due to my wife’s continued self-employment, we have a high debt-to-income ratio of about 55 percent to 60 percent. We’ve never been late with a payment and would like to reduce our unsecured debt in order to improve our credit scores. My score is 690 and my wife is at 640. We plan to sell our house in the next five years.

Is it advisable to try for a cash-out refinancing to reduce the debt or apply for an equity loan due to the reduced costs and pay down the unsecured debt? We would request that the lender pay off the cards directly. It seems like it would be difficult to obtain such a loan. Please help!

— Lou Longshot

Dear Lou,
The no-doc, low-doc days of 2005 are long gone. You’re not likely to find a willing lender to provide you with a cash-out refinancing, especially with credit scores in the 600s and with debt-to-income ratios as high as yours.

What’s your goal? Restructuring your debt and turning unsecured credit card debt into secured mortgage debt can reduce the interest rate on the debt. Since you plan to sell the house, you won’t face taking 30 years paying off last year’s expenses.

You’ll also free up your credit cards. They might be the cause of your financial issues. Did you build these balances because you’re spending more than you’re making? A reset gives you breathing room, but what about changing your spending habits? You should eventually want to own your home free and clear, not continually tap the equity like a piggy bank.

While a cash-out refinancing provides the benefit of a lower interest rate on your existing mortgage balance along with the cash out, you’ll pay the higher closing costs associated with a refinancing. Bankrate’s 2013 Closing Cost Survey estimates a national average of $2,400 for a $200,000 mortgage loan, not including title insurance. As you point out, a home equity line of credit should have much lower closing costs. The tradeoff is that the interest rate on the home equity line may be higher than the interest rate on a cash-out refinancing.

Rebuilding your credit takes time, and on-time payments. If you’ve never been late in your payments, then the problem with your credit history is probably all about the balances you’re carrying.

Paying down the balances should help your credit scores. Tapping your home’s equity is a logical way to do it. One potential problem is that you can also be dinged on your credit score for having too much home equity debt in the mix. But the types of credit used account for only about 10 percent of your credit score.

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