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Refinance: Turnaround or Trap?

refinance home loanEarlier this week I promised to talk more about refinancing your mortgage to deal with high-cost debt. A reporter for a financial publication asked me, “If you have lots of high-interest debt, what do you recommend doing about your mortgage?” While the simple answer is, “Refinance and pay it all off,” that could be very bad advice—and self-serving advice at that, coming from a loan originator.

Let’s set the stage: You own a home with plenty of equity. It’s worth $360,000 and you owe $200,000. Your mortgage has a 4.75% rate, and your payment is $1,140 per month. You’ve had the loan for five years, so you have a remaining term of 25 years.

You have accumulated credit card balances totaling $30,000. The minimum payment on the cards is $900 (3% of the outstanding balance). You have been trying for years to get that balance down, but most months, you pay the minimum. The balance just seems to creep up, as if by magic. Between the mortgage and the credit cards, you have $2,000 a month going out.

You can make the payments, but sometimes it’s uncomfortable. And even though you make all your payments on time, the credit card companies just raised your rate to 18%. Something about “exceeding a balance threshold,” they said.

Your Personal Senior Loan Consultant at the bank told you that by refinancing into a 3.75% loan, you could pay off all that consumer debt and save $975 a month. Good deal, right?

Probably not. First, as I mentioned earlier this week, you would be financing your credit card debt over a 30 year term—and the chances are that you don’t even remember what you bought with that money.

Is it a good idea to reduce the cost of your debt by refinancing? Absolutely—but you could be just digging yourself a deeper hole. Your credit card balances got so high because you often paid less than the full balance when the bill came. So first of all, you have to change your behavior. Once you have paid off those expensive cards, you have to resolve that whatever you charge on the card, you will pay the balance in full when the statement arrives. No. Exceptions. Credit cards are a real convenience, but they are a terrible way to borrow money.

When you tap into your home equity to pay off high interest debt, you can make it much easier to retire that debt; paying $900 each month on a $30,000 loan at 18% will pay it off in 48 months (if you don’t keep adding to it). The same payment on a 3.75% loan will pay it off in 36 months—a full year sooner.

You should consolidate consumer debt as a way to reduce your debt, not add to it. You do this by deciding how quickly you want to retire that portion of your home loan that paid off the consumer loans, then pay a certain amount extra to the principal each month. If you have taken out $30,000 cash to pay off the credit cards and you’d like to pay off that portion of the new loan in four years, you would add $500 to each monthly payment. After 48 months, the balance on your mortgage will have been paid down to $182,000—just what it would be on your present mortgage. The difference is that you will no longer have the credit card debt. If you decide to keep making that higher payment ($1,640 instead of $1,140), your home loan will be paid off in fifteen years. By following this approach, you will have eliminated expensive credit card debt, reduced your total outgo by $400 a month, and become the owner of a free-and-clear home in just 15 years.

This strategy may not be for everyone; after all, it does require some personal discipline. But if you can change your behavior in this one small way, you will reap the rewards for a very long time.

I invite your comments.

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