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Thinking Twice About Absorbing Debt Into a Mortgage

May 27, 2008

I’m very grateful.  I have been nosing around financial guru Dave Ramsey’s forums and ran across a post that probably saved me a bunch of money.

Let me backtrack for a moment.  Dave Ramsey isn’t a get rich quick guy, or a multi-level martketing guy or anything like that.  His philosophy is that debt is bad and encourages families to do everything in their ability to get rid of debt.   Once out of debt, Ramsey advises those same families to save up 2 to 3 months salary in a savings account.  Ramsey basically preaches financial responsibility.

I’m like most people, in way too much debt.  I’m stressed about it and am looking for any way to get out of it.  I thought about refinancing the house and absorbing our credit card debt.  The I ran across the following sage advice:

There’s a good reason lenders encourage folks to get cash out. They make a lot more money. But for the borrower, a cash out refi is a terribly expensive way to borrow money. In addition to putting up your home at risk as collateral to secure the debt, you’re paying interest for the entire life of the mortgage for the use of the cash. It’s actually a lot cheaper to borrow the money for a short term on a credit card. Because a loan is compound interest in reverse, Time is a more important factor than Rate in determining the total Interest. If you stretch out a loan for a long time to have a lower payment, it will still cost more, even if the rate is substantially lower.

To give you an example, let’s suppose you were getting $30K cash out to pay off a bad car loan:

    If you were paying $608 per month on a debt of $30,000 at 8.% it would be paid off in 60 months. The total interest would be $6,498.

    If you refinanced it in a cash-out mortgage for 30 years at 5.5% with 2.0% closing costs rolled in, the payment on $30,600 would only be $173.74 per month. But over the 30 years, the total interest would be $31,948. That’s 4.9 times more interest for the same amount of initial debt.

    At the end of 60 months when the original debt would have been paid off, you’ll still have 300 payments (25. years) of that extra $173.74 to go on the mortgage. Instead of having it paid off at that 60 month point, you will have already paid $8,118 in interest, and will still owe $28,293 of the original $30,000 debt.

If you were to sell the home in 5 years, carrying that extra $28,293 with 1.5% closing costs into a new 30 year mortgage at 6% would give you an extra $172.17 per month on the payment for the next mortgage, and would cost you $33,266 more interest over the life of the loan. So you’d be paying a total of $41,383 interest on a debt that you could have paid off in 60 months at a cost of $6,498 in interest if you hadn’t taken any cash out in the first place.

It’s even worse if you refi a mortgage that has less time remaining than you refinance.

    If you owed $200,000 on your mortgage at 6.0% for 25. more years the payment for P&I would be $1289 and the total cost would be $386,581 with $186,581 in interest.

    If you rolled in 2% closing costs plus the old debt into a new mortgage at 6.0% for 30. more years the payment for P&I on the total debt of $234,600 would be $1407 and the total cost would be $506,356 with $271,756 in interest. You’ve added $66,046 to the cost of the mortgage alone.

    At 60 months when the original consumer debt would have been paid off, you will still owe $218,306 on the new mortgage. At that time you would only have owed $179,864 on the old mortgage. So instead of having the original debt paid off, you owe $38,441. That’s $8,441 more than the original deb was to start with.

I’m very grateful to see the numbers in a real world situation.  Rolling your debt into a mortage is a horrible idea!

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2 Comments
  1. May 27, 2008 8:19 pm

    True enough. The much better way to use your home to pay debt is to take a home equity line of credit. These are offered for good-credit borrowers at prime minus 2 percent in many cases. Plus, you can get them at no closing costs at all.

    Borrowing 10K at 3 percent with no fees is a pretty good deal.

  2. May 28, 2008 12:47 am

    Jack, borrowing is not the way to go. How can you “pay debt” by taking “credit”? Is that like paying one credit card off by paying it with a credit card? The numbers above speak loudly…it is not worth taking your money out of the house through a loan situation.

    The best way to get the money you want is to wait and save up the money.

    And…

    The best way to pay off debt is to pay it off.

    http://www.beatingdebt.wordpress.com

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