A common—and generally wise—purpose for refinancing a mortgage is to consolidate other debts. The new mortgage not only pays off the old one, but also pays off other debts, usually at a lower interest rate and better terms.
Here’s a simple example:
John’s home is worth $220,000 and his current mortgage balance is $130,000, giving him $90,000 in equity ($220K - $130K = $90K). His mortgage payment (not including taxes and insurance), is $810/month. John also has $30,000 in credit card debt with a total payment of $500/month. His monthly debt payments total $1310. He refinances with a new mortgage that pays off the $130,000 mortgage and the $30,000 in credit cards, yielding a new mortgage of $160,000, with a new total payment of $764/month, which is his new monthly total debt payment. He’s now saving $546/month.
Key Benefits
A debt consolidation refinance carries some significant benefits, namely:
· Lower Overall Interest Rate – The average interest rate for a 30-yr conventional mortgage as of 8/5/15 is about 4.00% (FHA and VA loans are lower). The average interest rate for a credit card is 15.00%. Kind of a no-brainer. But, let’s say that your existing mortgage interest rate is fairly low to start with. Would you still get a better rate by refinancing? Returning to our example, if John’s existing mortgage interest rate was already 4.00% and he refinances to another 4.00% interest rate, it may seem as if the benefit is limited, but if we consider his overall interest rate (i.e. the weighted average of the interest rates of all of his debt), he is over 6% (6.1%, in fact).
· Lower Payments – The lower payments are achieved both by a lower interest rate for the consolidated debt, but also from lower payment requirements compared to the debt. Most credit card companies require payments of 1.5-2% of the balance (with a minimum of, say, $25/month). Mortgage amortization does not require such high payments, even though the interest rate is much lower.
· Simplicity – If John had 3 credit cards (totaling $30,000) plus his mortgage payment, he was making 4 separate payments each month, each with potentially different due dates, late fee arrangements, etc. A debt consolidation refinance consolidates the payments as well as the debt balances, making it so that John just makes 1 payment each month.
· Tax Benefits – Mortgage interest is usually tax deductible, but credit card interest is not. By paying off credit cards (or other debts) with a mortgage, the interest paid associated with that debt can now be deducted from one’s taxable income, saving them even more money.
Note that I am using credit cards as a primary example, but a debt consolidation refinance can be used to pay off anything. Common debts paid with this type of refinance are credit cards, lines of credit and personal/signature loans, car loans, medical bills, collection accounts and judgments, taxes, money owed to ex-spouses, other mortgages, student loans, 401K loans, etc. If you borrowed it, chances are it can be paid off in a debt consolidation refinance.
Maddening Misunderstandings
Despite the significant advantages of a debt consolidation refinance, there are several common misconceptions about the process and its consequences-
· Misconception #1: “By rolling the debt into my mortgage, there is greater risk that I could lose my house if I can’t make the payments.” – If your monthly payments are reduced as a result of a debt consolidation refinance, are you now more or less likely to struggle making the payments? Less likely, of course. Plus, unless you plan on declaring bankruptcy, you have to pay all of your debts. Would you rather do that at 15% or 4%? Finally, in the event that you do have trouble and declare bankruptcy, 9.9 times out of ten, your home is exempt. In truth, a debt consolidation refinance that reduces your payments actually REDUCES the risk that you could lose your home.
· Misconception #2: “If I refinance, it will take me longer to pay off my debts.” – If you have less than 30 years left on your mortgage and refinance with a new 30-yr loan, then yes, you will have extended your payoff date. BUT, if you don’t want to extend the pay-off date, then just set the term to whatever it was before. Returning to our example, if John had 25 years left on his original mortgage and still wanted to get out of debt in 25 years (instead of 30), he could just get a 25-yr mortgage instead. In that case, his payment would be $844/month…still $466 less than what he would be paying if he didn’t refinance. Additionally, if you just make the minimum payment on your credit card (as most everyone does), it will take about 33 years to pay it off…and you’ll do so at 15% interest. If monthly savings isn’t as important to you and you just want to pay off your debts faster, a debt consolidation refinance is still a good idea, since the interest rate is lower. Let’s say that John is comfortable with his $1310 monthly payment but wants his debts to be paid off faster. If he proceeded with the refinance but kept paying $1310/month, he would be out of debt in just 13 years. That’s 12 years faster and $135,000 cheaper than not refinancing.
· Misconception #3: “If I pay off other debts with a mortgage, I won’t have as much equity and that’s somehow bad.” – This one has always surprised me. It’s as if equity is somehow more sacred than other assets, like cash. What you should be most concerned about is your net worth, which is your assets minus your liabilities (debts). In John’s case, his home is worth $220,000 (his asset) and he owes $130,000 on his mortgage and $30,000 on his credit cards (his liabilities), so his net worth is $60,000 ($220k-$130k-$30k = $60k). If he refinances and consolidates his credit cards, his mortgage is now higher ($160K), but his net worth is still the same ($220k-$160k = $60k). So his net worth hasn’t changed and he’s saving over $500/month. His circumstances have only improved. Also, equity comes and goes. How many homeowners saw their home values fall in the last 7 years, wiping away trillions of dollars of equity? If you are diversified (i.e. you have your assets in other forms like cash or other investments, as well as equity), then you don’t lose everything when there’s a downturn in real estate.
On a final note, while my opinion about debt consolidation refinances is obviously positive (and biased), I must point out that it is not a cure-all for financial woes. No strategy or scheme can overcome poor money habits and lack of self-mastery. Anything can be misused, even a pay increase or winning the lottery. If you racked up your credit cards at the mall or Wendover, a debt consolidation refinance will most likely improve your situation, but will it keep you from ending up in that same boat later? A debt consolidation refinance is a powerful and valuable tool for a better future and achieving your financial goals; but you need to make sure you're doing your part to achieve those goals as well.
