It is common for people who have mortgages to have other debt as well, and this other debt is generally at a higher rate of interest. Often times, it can make sense to add this debt onto your mortgage if possible, which offers two main benefits.
The first benefit is interest savings, and that one is obvious to people, but the second one, managing cash flow, can also be pretty significant in helping people manage their other debt payments and their financial affairs in general.
How you get the ability to do this is by not only paying down the principal of your mortgage, which always happens over time, but also through the value of your home increasing over time, as they tend to do.
Increasing home value does not necessarily happen year over year, and some years the value of it may go down depending on market conditions, but over time real estate does tend to appreciate in value pretty nicely. Given the limited supply of prime real estate, and both the population and income growing, this is expected to continue indefinitely.
Home equity is defined as the market value of your property less the amount owed on the mortgage. While one cannot usually add this full amount to your mortgage, the amount you can add is based upon how much home equity you have.
Since there are fees involved in refinancing a mortgage, this is not something that you want to do too frequently, or for anything but substantial amounts. Often times though, it is in people’s best interests to refinance debt, or sometimes even to redo the amortization and set it longer to lower your payments to allow you to gain a surplus which can be used for other purposes.
Often, people will do both, or at least they should be doing both, meaning both adding debt and increasing the amortization to lower their payments and increase their cash flow, as well as saving money on interest payments. When you refinance higher interest debt, you save the difference in the rates, and mortgage rates are the lowest around, since the debt is secured by your home.
Using Home Equity to Reassign Existing Debt
When people get a mortgage, they often will have other debt, and this isn’t the time that one can add debt to the mortgage. If one wants to look after some or all of this debt, they can simply hold back part of their down payment, if they have it to use, and pay down their other debt with that.
This works out the same as adding debt to the mortgage, although that isn’t possible initially, as lenders will not lend more than the value of the property being mortgaged when they extend a mortgage. If they did, this extra loaned money would not be secured by the home value, if the total amount lent exceeded its value.
As time goes on though, people do accumulate equity in their home, as its value goes up and the mortgage gets paid down. Many people continue to hold other debt on a continual basis, and the opportunity arises where they may save interest by putting some of this debt on their mortgage.
Some people hesitate about doing this though when they should not, and this is the job of the lender, to do calculations for clients to show how much they will save in interest by adding other debt onto it.
These calculations tend to often not be all that accurate though, which is something you want to be aware of, and there is a tendency to portray cash flow increases as savings. If for instance you lower your overall payments by $300 a month by refinancing, this does not mean that you’re saving that much each month over the life of the mortgage term, because some of this so-called savings will come from amortizing the other debt over the life of the mortgage, and you can often pay even more interest with this strategy on this other debt if you’re not careful.
To illustrate this further, let’s say you set your amortization to 25 years. You have a car payment which is $400 a month right now. There is 3 years left on these payments. So, if you amortize this payment over the 25 years, the amount you’ll have to pay per month is going to be a lot less than $400, let’s say it’s $60 a month.
So that’s a difference of $340 a month, and some agents will have you believing that you are saving that much a month, which isn’t true at all of course. They may even multiply that amount over a long period of time, and then claim that the deal will save you that much, even though the $400 a month obligation does not continue past the 3 years, yet they try to represent this savings beyond that.
This is ridiculous but it does happen, and borrowers need to be aware of these tricks. Often the rep does not even get why this does not make sense though. This calculation does show the reduction in payments one enjoys during the period of the amortization of the other debts, in our case 3 years, but unless the debt is paid off during that time, one’s payments will increase when this 3 year period is over, and this is the part they don’t usually tell you.
Balancing Interest Savings with Cash Flow
There are a lot of situations that people get themselves into where they just cannot manage their obligations, or doing so makes things very difficult for them. They have taken on too much debt for whatever reason, and the cumulative payments can be a little too much for them. In these cases, amortizing shorter term debt over a longer term can be very helpful and even end up saving them in some cases.
The goal in these cases then becomes to reduce one’s overall payments, and while this can be done to some degree with loans, the longer amortization available with mortgages makes this a perfect product for refinancing debt.
Ideally, the plan here should be to free up as much cash as possible and then have clients both plan to use this extra money to reduce or prevent future borrowing, as well as having them put some of this extra money on the mortgage.
In our example, if we were just refinancing the car, let’s say we were able to reduce the interest on it by 2%, we would look to still pay it off over the 3 years by making prepayments on the mortgage, and this way it would work out to the same thing as getting the car loan at the reduced interest rate.
The lower payments that it would take to do this, by way of the interest savings, would free up cash for us which could be used to pay off the car faster or set aside for other purposes.
If we just do nothing though, this can lead to our taking 25 years or whatever to pay off the car, if it just sits on the mortgage all this time and we never make extra payments, and this may result in our paying quite a bit more in interest on the car loan over time. This may be acceptable in cases where freeing up the entire $340 in our example is necessary, and in some cases, it is, but we need to find a balance between the interest paid and the amount we can lower our payments with these deals.
With higher interest debt such as credit card debt, it is generally always preferable to get this debt on a mortgage, as people can take quite a while to pay this off anyway due to the high interest, and the sheer interest savings can make this a sweet deal even if you don’t pay extra to pay it off.
The Right Way to Approach Mortgage Refinancing
The ideal approach needs to be to look to both build yourself some reserve capital to handle current obligations as well as foreseeable future ones, and also use some of the savings to put back on your mortgage periodically, to pay down this refinanced debt in a way that better approximates how long you would take to pay it if it were not refinanced on your mortgage.
This way you are at least shooting for the best of both worlds, to lower your overall payments and put you more in control of where your money goes, and to lower your overall interest payments by moving higher interest debt to a lower interest product.
Should one need to free up a lot of capital, that’s an objective that can be achieved without really interfering with the long-term plan of paying down the debt that you add on to the mortgage faster. That should be the goal in all cases, and even when we have overextended our credit to the point where we can no longer keep up with the payments, refinancing can and should allow us to turn the ship around.
If we have ourselves close to the threshold of our capacity, there may not be much room for unforeseen expenses that arise that require additional borrowing. This is where a lot of people get in trouble, and refinances can help fix these problems, but it’s better to keep enough capacity in reserve to be able to manage these issues comfortably as they arise.
The only way to extend your spending capacity without having to deal with increased payments that may go beyond your ability to make payments is to have some savings built up. People who are in what is termed the accumulation period of life, where they spend close to what they make or in some cases more, in the short to medium term anyway, need to realize that without savings, they are putting their financial health at risk.
Perhaps the biggest benefit to debt restructuring through mortgage refinancing is how this allows us to start saving some money, setting some aside for future use, although this is only a benefit if we are willing to take advantage of it.
If we seek to pursue financial health, it is very important to realize the benefit of this, and regardless of what stage you are the financial life cycle, saving to some extent is both beneficial and required.
This way, instead of having to restructure our debt, we’ll be able to manage things without needing to do so. You can only refinance so often and when people look to go to the well too often it will usually end up going dry, where you can’t add any more debt but you need to, and you can end up in an unhappy place this way.