When it comes to consolidating debt by refinancing a mortgage, a lot of non-finance people will claim it to be a “bad” thing. After all, these people have probably worked very hard to pay their mortgage down and are now enjoying the fact that their shortened remaining amortization will make them among the few who are mortgage-free. Without a doubt, their hard work deserves recognition.
The reality, however, is that even with a reduced amortization while carrying tremendous amounts of consumer debt does not make any sense whatsoever. Refinancing a mortgage and taking advantage of the unused equity in your home to repay consumer debt makes the most sense and we highlight three of the most obvious reasons here.
First off, interest rates on consumer debt are normally way higher than rates people pay on mortgages. This is because real estate is still considered the best form of consumer collateral. Refinancing a mortgage to pay out consumder debt means lower interest costs over the course of the repayment period. Since people owe this debt regardless of whether it is secured by a mortgage or unsecured, the only difference is that consumer debt gets paid with the mortgage and not with mailed credit card or loan statements. What will you do with the interest savings?
Number two is that the monthly payments on consumer debt are normally much higher than on mortgages. For this reason, refinance a mortgage to improve cash flow is a common occurrence. To illustrate, consider a loan of $50,000 at a rate of 8.9% with a term of 6 years compared to a mortgage of the same amount at a rate of 5.75% over a 25 year amortization. The gain in cash flow is $586.24 because the mortgage has a longer repayment period. Now, what would you do with your extra cash flow every month?
Three is for simplicity. The average North American carries balances on thirteen different credit cards. This suggests that this average person is making thirteen different payments on a monthly basis plus a regular mortgage payment. By refinancing a mortgage, those thirteen different payments will get replaced by the lone mortgage payment. How will you spend that extra time?
Of course, nobody who looks at refinancing a mortgage plans on carrying that debt until the end of time. The goal is always to be mortgage-free, but when people carry consumer debt at the cost of paying off that mortgage, they are actually taking steps backward. All you have to do is consider the higher costs and payments associated with consumer debt. A common objective might be that securing consumer debt with your home puts your house at risk. Well, if you can’t make your mortgage payment, the mortgage company will foreclose, regardless of whether you owe money to someone else. With that in mind, would it not make more sense to use your equity so that you increase cash flow and reduce the risk of default on the mortgage?
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