May 6, 2002
"I have two mortgages plus a lot of
short-term debt with high interest rates. Because my house has appreciated
substantially in recent years, I�m sure I can save money by consolidating the
short-term debt into one of my mortgages, but which one?"
I recently added three debt consolidation
calculators (1a, 1b and 1c) to my web site, designed for three categories of borrowers:
*Those about to purchase a house who may
want to consolidate non-mortgage debt in the purchase mortgage.
*Those with an existing first mortgage who
may want to consolidate non-mortgage debt, either by refinancing the first
mortgage to include the non-mortgage debt, or by taking out a new second.
*Those with existing first and second
mortgages who have a variety of consolidation options.
You fall in the third group, which is the
most complex because of the multiple options:
*Status Quo - means you make no change.
*Consolidate Non-Mortgage Debt in First - means that you consolidate your
existing non-mortgage debt by doing a cash-out refinance on your first
mortgage, leaving your second mortgage as it is.
*Consolidate 2nd Mortgage in First - means that you consolidate your existing
second mortgage by doing a cash-out refinance on your first mortgage, leaving
non-mortgage debt as it is.
*Consolidate Non-Mortgage Debt and Second Mortgage in First - means that you
consolidate both your existing non-mortgage debt and your second mortgage by
doing a cash-out refinance on your first mortgage.
*Consolidate Non-Mortgage Debt in Second - means that you consolidate your
existing non-mortgage debt by doing a cash-out
refinance on your second mortgage, leaving your first mortgage as it is.
The calculator provides two types of
information about each of these options. One is the total monthly payment, which
consists of mortgage payments, mortgage insurance premiums if any, and
non-mortgage debt payments if any. Borrowers on tight budgets must be concerned
with the monthly payment, but it should not be the major determinant of their
choice. It fails to reflect differences in tax savings or debt reduction as
between the options.
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, 5 years, the total cost of each
option is the sum of the monthly payments over 5 years including lost interest,
less the tax savings and reduction in total debt over that period.
When I entered the numbers you sent me, I
found that consolidating both the non-mortgage debt and the second mortgage in a
new first mortgage resulted in the lowest monthly payment. It was $1446 compared
to $1790 under the status quo. However, this consolidation option raised
total costs over 5 years from $56,681 under the status quo to $61,058.
Consolidating in this way would be selling out your future wealth for a lower
payment, which I view as a pact with the devil.
The better alternative would be to
consolidate your non-mortgage debt in a new second mortgage, leaving the first
mortgage alone. The payment would be $1549, which is higher than the payment
under the comprehensive consolidation option, although well below the status quo
payment of $1790. More important, the total cost would be the lowest of all the
options at $54,867.
A critical question is what you do after you
consolidate? What you should do is use the monthly savings of $241 to
accelerate the pay down of principal on your second mortgage.
Unfortunately, many borrowers in your
situation interpret 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. Then they write me letters like this one.
"We kept adding to our second mortgage
to pay off credit card debt�the rate is now up to 13.75%�we don�t have
enough equity to break even if we sell... we feel trapped".
The trap was of their own creation. Don�t
let it happen to you.
Copyright Jack Guttentag 2002