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Debt Consolidation With a Second Mortgage

Debt Consolidation With a Second Mortgage

November 6, 1999, Revised February 20, 2004, Revised November 30, 2004

"I have a bad credit card habit, with 7 cards and $30,000 in balances, at rates ranging from 10% to 19%. I have been offered a $35,000 second mortgage at 14% for 25 years to consolidate them, which would substantially reduce my monthly payments, and there would be no cash required. Is there any reason I shouldn't do it?"

Quite a few, in fact.

Don't Consolidate Low-Rate Debts

The interest rate on some of your credit card debt is lower than the rate on the second mortgage. You don't want to replace a 10% loan with a 14% loan. If you do consolidate, make it partial, leaving the lower-rate debt alone. This wouldn't apply, of course, if the 10% is an "introductory rate" that will go above 14% in a short time.

A Second Mortgage Reduces Your Flexibility

Adding a second mortgage to the first may hamper your ability to refinance the first when a profitable opportunity to do so appears. When a first mortgage is paid off, an existing second mortgage automatically becomes a first mortgage. This makes it impossible to replace the old first mortgage with a new one unless the second mortgage lender provides the refinancing lender with a written statement indicating a willingness to subordinate the second mortgage to a new first mortgage. Many second mortgage lenders will to do this, charging fees that range from nominal to extortionate, but some won't do it at all.

A Second Mortgage May Extend the Life of Mortgage Insurance on the First Mortgage

Adding a second mortgage will also extend the period during which you must pay for mortgage insurance on your first mortgage, perhaps indefinitely. While you do not fall under the new rules that require lenders to cancel mortgage insurance when certain conditions are met, lenders will usually cancel a policy voluntarily if the balance has been paid down appreciably over several years and is less than 75-80% of property value. But they may not cancel it if you have added a second mortgage.

A Second Mortgage May Make You Immobile

If the second mortgage results in your total mortgage debt exceeding the value of the property, you may lose your mobility. Suppose you are offered a better job in another city that would require that you relocate. If you owe $120,000 on a $100,000 house, selling the house means finding $20,000 in cash to pay off both mortgages. If you can't find the cash, the only way to relocate is to default, which would prevent you from buying a house in your new location. I have received a number of letters from people who have found themselves in exactly this situation, asking what they can do, and it depresses me to have to tell them that unless they can find a guardian angel, they are stuck.

A Second Mortgage May Be Costly

The upfront charges on this second mortgage may be excessive. You stopped worrying about these charges when they told you that no cash would be required, but in fact they are charging you $5,000. That's the difference between the $35,000 you are borrowing and the $30,000 you need to pay off your debts.

I preach a lot to consumers financing home purchases about the large savings that are possible if they shop multiple lenders. But the arguments for shopping are even more compelling for existing homeowners taking out a second mortgage. The range of terms offered on a given deal is much wider in this market than in the market for first mortgages.

Whether or not you can do better than the offer you have on the table is going to depend heavily on how good your credit is. If you have a credit score above 680, you probably can do better whereas if you are below 600 you probably can't. You can get your score at www.myfico.com. 

Will You Become a Credit Junkie?

The lower payment that results from a 25-year term could tempt you into building up your credit card balances all over again. This could result in so much debt you'll never get out from under.

If you are not dissuaded by these reasons and go ahead to consolidate, you should try to control your addiction by avoiding a large drop in the monthly payment. Shift the second mortgage to 10 or 15 years, whichever provides a total payment close to the one you have now. With the lower rate and short term, you will at least have a fighting chance of becoming an equity-builder rather than a credit card junky.

Copyright Jack Guttentag 2004


Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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