Hawaii The Mortgage Professor: Debt consolidation during a period of rising interest rates
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Joseph A. Garcia, BIC
Christina Sotelo, BA
808-329-3121
West Hawaii Real Estate | October 26, 2018 15
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Debt consolidation is the
conversion of high-rate
debt into lower-rate debt
in order to reduce total
interest costs. Homeowners with large
amounts of credit card debt who have
unused borrowing power on their
home have a consolidation option.
Whether or not it is in the
homeowner’s long-run interest to
exercise the option, however, turns
out to be a challenging question,
the answer to which depends on the
specifics of the individual case. That
makes it a calculator problem, where
the challenge becomes finding the
right calculator. This article will help
with that.
Consolidation options of a
homeowner with two mortgages
Homeowners who have both a first
and a second mortgage have the most
consolidation options:
• They can consolidate their existing
non-mortgage debt into their first
mortgage by doing a cash-out
refinance on the first mortgage,
leaving the second mortgage as it
is. (Note: A cash-out refinance is a
loan for an amount that exceeds the
balance on the loan that is paid off).
• They can consolidate their existing
non-mortgage debt into the second
mortgage by doing a cash-out
refinance on the second mortgage,
leaving the first mortgage as it is.
• They can consolidate their existing
non-mortgage debt and the second
mortgage into the first mortgage by
doing a cash-out refinance on the first
mortgage.
Calculator 1c on my website,
www.mtgprofessor.com, provides the
information about these options that is
needed to make an informed decision.
The calculator provides two types
of information about each option.
One is the total monthly payment,
which consists of the mortgage
payment, mortgage insurance
premium payment if any, and nonmortgage
debt payments if any.
Borrowers on tight budgets must be
concerned that the monthly payment
is affordable, but it should not be the
major determinant of their choice.
The second type of information
the calculator provides about all
the options is their total cost over a
period specified by the user. If the
user’s time horizon is, say, five years,
the total cost of each option is the
sum of the monthly payments over
five years including lost interest, less
the tax savings and reduction in total
debt over that period. A borrower
looking to have the largest amount of
wealth possible at retirement should
seek to minimize this cost.
Homeowners with one mortgage
can use a shortcut
Homeowners who have one
mortgage and a large amount of highcost
short-term debt that they want to
pay off have only two options. They
can refinance their mortgage with
enough cash-out to pay off the shortterm
debt, or they can take a new
second mortgage. You can take the
shortcut using my calculator 3d.
The most important factor
determining whether a debt
consolidation is cheaper using a second
mortgage or a cash-out refinance is the
current level of interest rates relative to
those at the time the first mortgage was
taken out. If current levels are lower,
a cash-out refinancing is likely to be
better because the new first mortgage
can have a lower rate than the existing
one. Since rates have been trending up
recently after many years of low rates,
a second mortgage is likely to prove
cheaper in many cases. However, many
other factors enter the equation.
These factors are pulled together by
my calculator 3d, which computes all
costs of both options over a future time
period specified by the user. It also
shows a break-even interest rate on the
second mortgage — the highest rate
you can pay on the second and come
out ahead of the refinance option.
The second mortgage is the lesscostly
option if it is available at an
interest rate below the break-even rate.
The aftermath of debt
consolidation
A critical question is what borrowers
do after they consolidate. Borrowers
who reduce their monthly payments
should use the monthly savings to
accelerate the pay-down of their
mortgage balance, but many don’t.
Some view a payment-reduction
consolidation as a license to take on
more non-mortgage debt. A few years
later, they look to consolidate again. If
their house has appreciated enough,
they may be able to, but sooner or
later they run out of equity. Some then
write me asking how they can get out
of the trap they dug for themselves.
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