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Refinancing to Consolidate Debt: Is It a Trap?

real estate concept with US dollars and mini house, shallow dofI recently gave an interview to a reporter about refinancing for a financial publication. She asked me this question:

“Why is paying lower-interest mortgage instead of high-interest debt (like credit cards) a bad idea? How can this impact you in the long term? If you have lots of debt or high-interest debt, what do you recommend doing about your mortgage?”

Actually, it was three questions, but they are all good ones. What she really was asking was this:

  1. Is refinancing to consolidate consumer debt a bad idea?
  2. What would be the long-term harm to doing this?
  3. Is there some way that a mortgage can be used productively if you are carrying a lot of debt?

The way this reporter framed her question gave me some clue about her “angle”—that debt consolidation may be a bad idea. Although it is not a yes/no question, here is how I responded to her.

“Debt consolidation” refers to the practice of taking one large loan to pay off multiple smaller ones. This is typically done to reduce the monthly payment, and in recent years, home equity has been a sort of ATM to get money for that purpose.

If I have managed to rack up $40,000 in credit card debt (yes, we have seen that) and another $25,000 in an auto loan, I may be saddled with total payments approaching $1,800 per month. I realize that I have plenty of equity in my home, so I apply for a cash-out refinance at 3.75%. If I am reducing my mortgage rate from, say, 4.75%, my monthly payment will only increase by $85.00—but I will pay off $65,000 in consumer debt, getting rid of that nasty $1,800 in non-deductible loan payment. Suddenly life is good again: I have no car payment, those formerly maxed-out credit cards now have a zero balance, and I have over $1,700 more money each month. Winner.

But is this really a good thing? First of all, I have converted all that consumer debt to a 30 year mortgage. Is it really a good idea to finance a car for 30 years? And the credit card balance: maybe a big chunk of that debt was for that fancy cruise I took with the missus two years ago. Should I be paying for that over a 30 year period?

The answers to those two questions should be obvious; but there is another trap in this refinance scenario. It lies in what I may do once I have paid those credit cards to zero. How long will it take me to run those cards back up to their maximum? If I spend like the proverbial drunken sailor for a few months, then pay the minimum required (typically 3% of the outstanding balance), I could get into the same predicament as before—and I would have already used my home equity to get out of it.

The real answer is in the way we tend to use credit cards. Those plastic rectangles are undeniably convenient—but they are a terrible (and potentially dangerous) way to borrow money. If we can adopt the mindset that when we slap down the plastic we are really spending cash, then back that up by paying the balances in full each month, we will avoid the trap.

There are some financial “gurus” who claim that credit cards are evil, largely because we consumers cannot be trusted to pay off the balances. They advocate not only paying these accounts off (a very good idea), but also to close the accounts, so we won’t fall prey to temptation. One reason why this is a bad idea is that it will make subsequent mortgage financing far more difficult and costly. I will explore that in another article soon.

The reporter’s third question, “If you have lots of debt or high-interest debt, what do you recommend doing about your mortgage,” deserves a more detailed answer than I have space for today. That question will be the subject of an article later this week.

I invite your comments.

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