Homeowners with high-interest debt may have the option to consolidate that debt into their mortgage through a refinance (however, you typically need at least 20 per cent equity after the refinance and you’d need to qualify for the larger loan based on income). Here’s a look at the benefits and potential downsides.
- Instead of sending separate payments to your mortgage company and your other lenders, you’d make one payment, and many people prefer this simplicity.
- Consolidating can improve overall cash flow. If you are paying $500 a month for a credit card or a line of credit, then adding that balance your mortgage and amortizing it over the life of your loan would reduce the monthly payments. Since you’re already used to paying that $500 a month, it’s best if you can contribute the amount back into their mortgage to pay it off sooner or put the extra towards savings rather than simply absorbing it into your spending.
- Mortgages typically carry lower interest rates. Mortgages and car loans are what’s called secured loans, because the lender can foreclose on the property or repossess the car if you default. Credit cards and other types of loans are unsecured, because there’s nothing for lenders to recover, so they carry a higher interest rate (often around 20 per cent for credit cards or 5-7.5 per cent for a line of credit). Once you consolidate, you’d pay your mortgage’s interest rate, which would typically be a lot lower and save you on interest.
- Treating your home like an ATM can be risky. If you’re recovering from debts incurred by a one-time setback such as an illness, job loss or divorce, then that’s a very different scenario than paying off debts created by careless lifestyle spending. While lenders would typically require you to maintain at least 20 per cent equity in the home, if prices have depreciated significantly by the time you sell, you could lose money, which wouldn’t help your financial situation.
- If you amortize your debts over a longer time frame than before (say 30 years) without making extra principal payments, you could wind up paying less per month but more interest over the life of the loan.
Here’s a real-life example to illustrate how consolidating debt into your mortgage works:
I have clients who owe $385,000 on a property in Kelowna, B.C. and want to consolidate $80,000 worth of debt from renovations and an outside building on their land that could nto be included into their original mortgage. The appraised value of their home is $535,000, so they have nearly 30 per cent equity currently and can get a mortgage for up to $428,000 assuming they qualify based on income.
Their current rate is 4.34 per cent (amortized over 22 years)
After paying out the mortgage and the $11,000 penalty they can consolidate $33,000 of debt.
Their current payment is $2,238.39 + 1,050 (debt payment for 25000) = 3288 + other debt that was not included in the consolidation
Their new payment will be $1,699 based on a 30-year amortization and 2.55 per cent (which also includes $25,000 consolidated debt) = 1699 + other debt that was not included in the consolidation
Their monthly savings will be $1,589!
That’s money they can put towards their other debt that was not included in the consolidation. Because we also increased the amortization period, they can put a portion of their savings back to their payment to reduce their amortization. If they switch to accelerated bi-weekly payments and put an extra $125 towards their payments, they will take 8 years off their mortgage and save over $45,000 in interest.
In this scenario, debt consolidation and cash flow were really important to the clients so a refinance made sense for them. Your situation may be different, so I’d encourage you to consult an independent mortgage broker and discuss your goals.