Debt Consolidation Refinance - Doing it Wrong vs. Doing it Right

There's a lot that gets written on this subject, mostly by loan officers looking for business. Well, don't think I'm not looking for business, but not with this post. Or if anybody calls me because of this, at least I'll know they understand how to do it right.

The basic come-on is this: Your home has appreciated in value, and is worth more than you paid for it, so now you have equity on the one hand. On the other hand, you have loads of consumer debt, which is costing you hundreds or even thousands of dollars per month, which is impacting your lifestyle. So you borrow on the equity in your home and save money on your payments as well as causing them to be tax deductible in most cases, or at least so the traditional thinking goes. In actuality, it's only the actual purchase money where the debt is tax deductible, while cash out is not. My understanding is that the IRS has been starting to crack down on this.

Let's illustrate the situation with some numbers. Let's say Arnie and Annie have a $300,000 loan on a home that they bought in 1998, and comparable properties in the neighborhood are now selling for $600,000. This is 300,000 in equity.

On the other hand, because they are American consumers, Arnie and Annie have a hard time living within their means. They've got $15,000 in consumer credit, a $10,000 home improvement loan, and two new SUVs with associated debt of $20,000 and $30,000. These are fairly typical numbers.

Arnie and Annie's mortgage payments are currently $1720 per month, because they refinanced to 5.25% in 2003 when the rates hit bottom. Their monthly payments on the credit cards are $400. The payments on the SUVs are $500 and $600 per month, respectively. The payment on their $10,000 home improvement loan for landscaping is maybe $150. Arnie and Annie are forking out $3370 per month without taking into account stuff like property taxes, insurance, utilities, etcetera. It's really cramping their lifestyle.

Suppose they consolidate these loans into one payment on a thirty year home loan? All right, so it costs them anywhere from zero to $20,000 to get the loan done. Let's split the difference and say $10,000. That's about two points plus closing costs.

This adds up to a $385,000 loan. When I originally wrote this article, that was a jumbo loan amount, but that is no longer the case. With a 30 day lock, that would have gotten you 5.875% or thereabouts when I originally wrote this on a thirty year fixed rate loan. The new payment: $2277. Voila! Despite the higher interest rate, Arnie and Annie are saving almost $1100 per month!

Or are they? On the credit cards, their monthly interest was $225; their $400 payment would have paid the cards off in less than five years. The interest on the SUVs was $333 total on the two, and their payments would have had them done in about five years. The home improvement was a ten year loan but even so their monthly interest was only $75. Now these are all thirty year debts. The monthly interest on their old home loan was $1312. The interest charges on their home loan is now $1884, where total interest was $1945 previously. So they are actually saving money on interest.

The difference is that now they're not paying the old loans off as fast - they've spread the principal over thirty years. In the meantime, the bank is getting all this lovely money in the form of interest from them, and if they refinance about every two years as most people seem to do, this is $85,000 more that they owe on their home, and that Arnie and Annie will pay points and fees on every time they refinance! Meanwhile, Annie and Arnie are quite often out charging up more debt they'll consolidate into their home loan, and they'll keep doing this trick for as long as they can.

Let's assume Annie and Arnie beat the odds and don't refinance for five full years. This puts them ahead of 95 percent of the people out there. Let's look at where they'll be five years out if they make the minimum payment. They will owe $357,700 on their home. On the plus side, they will have had $66,000 to spend on other things (and they likely will, if they are typical Americans). Total debt: $357,700.

If they had continued making their previous payments, they would now owe $272,100. Plus they would be done with the SUV's and the credit cards and would only owe $6600 on the home improvement loan which they could now concentrate on. Total debts: 278,700.

Net difference: $79,000. Subtract that $66,000 they had real good time with (and nothing to show for), and they're still $13,000 in the hole.

They might skate with a $572 per month potential additional deduction, assuming they are willing to risk the wrath of the IRS as the "cash out" is not supposed to be deductible and the IRS is getting better at picking it up. Assuming they are in the 28% tax bracket and get to deduct the full amount, that gives them $9,600 less that they owe the government in taxes. Net amount Annie and Arnie are out are out: $3400, in addition to being set up for higher fees on future loans, and having a loan balance $77,100 higher. Additional interest they will pay because of the higher balance if they can get a loan at 5 percent even: $3855 per year.

Sounds like an awful bargain doesn't it? Many consumers have done this three and four times, or more. I run across people who bought their home in the early 1970s, and have mortgage balances ten to twelve times the original purchase price.

That's doing it wrong. Now I'm going to talk about doing it right. Suppose that instead of milking our equity for cash flow, where we're trying to minimize our monthly payments, we do it differently. Same situation, same numbers, but instead of spending that $993 per month, we use it to pay down our mortgage.

Actually, let's pay $3300 per month, so we still have $70 per month to spend elsewhere. After five years, we still owe $286,600. We got $4200 to spend elsewhere. And all of our other debts are gone. In addition, there's that illicit $9600 in tax reductions. Net amount to us versus the "do nothing" option: $5800, although we still owe $8000 more, and if we get a 7% loan, that'll cost us $560 per year. Notice that at this point, the benefits, while tangible, are still fairly small. Furthermore, if we refinanced or sold before this point, as ninety-five percent of everyone does, any benefits we may have gotten in the future disappear.

But: If we keep making that $3300 payment after those five years, and don't roll anything more into the loan, then the mortgage is paid off and we are debt free - the house is paid off, and the other debts are history - in less than ten more years! This relies upon us being thrifty and keeping those old SUV's going and not charging up any more credit and not doing anything else to make the debt worse. In short, not giving in to the marketing culture, not forking over money you don't have, not running up the payments on consumer stuff again. Many people say they won't. Few actually manage it.

So you see, even if you do it right, it takes years to show the benefits of this kind of refinance. This is years of doing something that they do not have to that most folks just won't do. If you have an unsustainable cash flow situation, by all means you've got to do something about it, but don't kid yourself that it's financially fantastic. On the other hand, if you're one of those who have to ability to make the scenario in the last paragraph (or something like it) happen, it's well worth doing.

This hypothesis is highly sensitive to initial assumptions. I previously assumed that Annie and Arnie are and always have been top of the line borrowers, able to qualify for anything. Suppose they weren't? Suppose they were in a C grade loan at 7.25%, but now they qualify A paper at 5.875. With a payment of $2070 per month formerly, of which $1812 was interest, the new loan saves them $1450 per month in minimum payments and $561 in actual interest while still saving about $1209 on their taxes over five years. You'd have owed $288,000 on the old program, now even if you put in only the same $3300 per month in payments, you're $1400 ahead of where you would have been on the balance, and you still had about $400 per month to spend. On the other hand, if Annie and Arnie were A paper but now they are applying for a C grade loan, it cannot be justified on anything except "the cash flow keeps us out of bankruptcy!" because it's financial disaster.

Some alert people will have noticed I didn't explicitly include the $10,000 cost of the loan in the computations of whether you're better off. That's because it is gone, sunk, included in the computations of where you ended up. It was part of your initial loan balance if you did it, included in the ending balance, and therefore included in the computations of whether you were better off. Now, if the cost of doing the loan were lower, there would be somewhat larger benefits a little bit faster, and indeed a lower cost loan is probably a better idea for most people, even though it means the rate and payment will be slightly higher. See my article on Why You Should Ignore APR for more.

The important thing to remember is to not get distracted by the fact that your minimum monthly payment goes down, and see if you (and your prospective loan officer) can come up with a loan and a plan that really makes you better off down the line, instead of one that sucks the life out of you financially, like the vast majority of these scenarios do.

Caveat Emptor

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