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November 22, 2004
Some home
buyers try to kill two birds with one stone by consolidating their debts in the
new purchase mortgage. Usually this is not a good idea, as in the case
illustrated below.
"I have $30,000 in cash for a down payment on
the $300,000 house I am purchasing. I also have $15,000 of credit card debt at
12% that I would love to get rid of. The loan officer says I can roll it into a
new $285,000 30-year mortgage at 6%. This cuts the rate on my credit card debt
in half and makes it deductible. Further, my total monthly payment would be only
$1891, compared to $2051 if I didn�t consolidate and took a $270,000 loan. Is
there any reason I shouldn�t consolidate?"
Yes, appearances to the contrary
notwithstanding, this consolidation will make you poorer.
True, the rate on the mortgage is well below
the rate on your credit card debt, and mortgage interest is tax deductible as
well. However, if you increase the size of your loan from $270,000 to $285,000,
you will increase either the mortgage insurance premium or the interest rate on
the purchase mortgage. It takes only a �% rate increase on $285,000 to offset
the savings from a 6% rate reduction (including the shift to deductability) on
$15,000 of credit card debt.
Consolidation would also reduce your total
monthly payment, but that is mainly because you would be paying down your debt
more slowly. If you consolidate, you will owe $260,484 at the end of 6 years,
which is your best guess as to how long you will be in your new house. If you
don�t consolidate, you will owe only $246,774.
These numbers and the others cited below are
drawn from calculator 1a on my web site. I used this calculator to determine
your total costs over 6 years if you: a. Don�t consolidate, which means
you take the first mortgage for $270,000 and leave the non-mortgage debt as is;
b. Consolidate in the first mortgage, which means that you take the first
mortgage for $285,000 and pay off the non-mortgage debt; and c. Consolidate
in a second mortgage, which means that you take out the first mortgage for
$270,000 to buy the house, and afterwards you take a second mortgage for $15,000
to pay off the non-mortgage debt.
Based on what you told me, I entered the
terms at which you can borrow under all three options. The $270,000 and the
$285,000 first mortgages are both no-cost at 6% for 30 years -- they differ only
in the mortgage insurance premium, which the calculator knows. The $15,000
second mortgage is also no-cost at 10% for 15 years. You are in the 25% tax
bracket and want interest loss to be calculated at 2%.
The calculator measures cost as total monthly
payments over the 6-year period; plus the lost interest on those payments
(interest that could have been earned but wasn�t); minus the tax savings on
interest, including the interest earnings on tax savings; minus the reduction in
debt balances over the 6 years.
Your costs are $89,904 without consolidation,
$92,311 with consolidation into the first mortgage, and $89,523 with
consolidation into the second mortgage. While consolidation in the first
mortgage rids you of the high payments on the non-mortgage debt and increases
your tax savings, these are more than offset by higher mortgage insurance
premiums and smaller debt reduction. Consolidation with the 10% second mortgage,
on the other hand, turns out to be slightly profitable.
In making decisions about consolidation,
borrowers make two kinds of mistakes. One is to base the decision on the monthly
payment, ignoring what happens to the loan balance. This mistake pervades many
financial decisions.
The second mistake is for borrowers to decide
in advance that they are going to consolidate, and only price mortgages that
allow it. Their focus is the cost difference between the non-mortgage debt and
the mortgage that would consolidate that debt. They ignore the fact that if they
don�t consolidate, their mortgage would be smaller and therefore less costly.
One benefit of using a calculator is the
discipline it imposes. It forces you to consider all the options, and to collect
all the data required to assess each option.
Some borrowers are allergic to calculators
and need a rule of thumb. Unfortunately, the common one that says "consolidation
is profitable if the rate on the first mortgage is below the rate on
non-mortgage debt", is wrong most of the time. Replace it with "consolidation is
profitable if the rate on the first mortgage is below the rate on non-mortgage
debt, and if the rate or mortgage insurance premium on the first mortgage
is no higher with consolidation than without." This one will be right most of
the time.
Copyright Jack Guttentag 2004
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