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Refinancing? Weigh risks of debt consolidation

With mortgage rates still near historic lows, consolidating credit card debt in a refinance can substantially lower monthly expenses. Yet many financial experts advise against it.
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With mortgage rates still near historic lows, consolidating credit card debt in a refinance can substantially lower monthly expenses. Yet many financial experts advise against it.

Take the example of JoAnn and Ray Katz. Three years after Ray left an executive position, he found himself earning a fraction of his former income, while his self-employed wife, JoAnn, struggled to make up the difference in a faltering economy. With their savings dwindling and credit card debt mounting, they looked to their most valuable assets: their center-city Philadelphia home and a second house they were renting out. "We were property-rich and income-poor," says JoAnn.

The couple had refinanced six years before, but when mortgage rates dropped to historic lows in May, they saw an opportunity to eliminate their credit card debt by refinancing their home and rolling $25,000 of credit card debt into the loan. Thanks to an excellent credit rating and an appraisal valuing the house at $345,000 — four times what they owed on it — Ray and JoAnn managed to lock in a 30-year fixed mortgage interest rate of 4.8 percent, two points lower than before. They're now saving $1,000 per month — $350 less in mortgage, $650 less in credit card payments.

"I would only suggest this as a last-gasp strategy," says Susan Reynolds, author of "One-Income Household." "In general, rolling credit card debt into mortgage loans is not a good idea. You will pay significantly more in interest over the life of the homeowner's loan than you would if you chipped away at your credit card debt over a period of three to five years. Remember, home equity loans are secured. Credit cards are not. If you renege, they can pester you for payment and ding your credit report, but they cannot confiscate your home."

Todd Huettner, president of Huettner Capital, a mortgage brokerage specializing in debt consolidation, advises homeowners to answer three questions before rolling debt into a home loan:

  • Why do you have this debt? "If you're spending more than you can afford, consolidating your debt will not improve your spending habits and will likely be harmful in the long run," says Huettner.
  • What are the costs of consolidating the debt? Those additional costs can add up to thousands of dollars compared to a regular refinance. If it doesn't make sense to refinance without the debt, you're probably spending more than you're saving. "If rates are low enough, the costs of a refinance should be paid back by interest savings within the first five years, preferably the first two," says Huettner. "If not, you're paying a lot in closing costs and that will offset any interest savings. I have even seen people try to cash out equity from their house even though it meant the new loan would have a higher interest rate."
  • Is there a more effective way to eliminate your debt than rolling it into your home loan? For example, a regular refinance may produce enough cash to cover the debt. "By timing the closing and your current loan payments, calculating any escrow refund and using incidental cash back, you can include several thousand dollars in your loan that wind up in your pocket," says Huettner. "For people who don't have much debt or where the costs of the cash-out are too high, this is often a better alternative." If your credit is good, there are still some 0 percent balance transfer credit cards that could help you pay the balance faster.

After working with nearly 5,000 families, Susan White of PlanPlus Inc. has her own reasons for advising against rolling debt into home loans. "The theory of turning higher debt rates (credit cards) into lower ones (mortgage) is a great idea," says White in an e-mail, "but it usually doesn't work because many of the people who end up in this situation have a habit of spending without conscious decision making."

Breaking bad habits
Gayle and Jim McWeeney are determined to break that habit. They refinanced their New Jersey home in July, rolling $30,000 of credit card and car loan debt into their 30-year fixed-rate loan. It was their third refi since buying their house in 1995 and, this time, they hired a professional adviser. Since much of their credit card debt went toward home repairs, he convinced them to take out an extra $20,000 to stash away as an emergency fund. "Homes are money pits," Gayle says.

While the couple's mortgage payment increased by $175 (they were hoping to reduce their rate from 6 1/8 to 5 percent, but their broker locked in late), they netted $700 in monthly savings. Their adviser also helped them design a plan to avoid future debt and pay off their mortgage early. "It's extremely helpful to have a good adviser," Gayle says. "Not only does he help us think outside the box, he will hold us accountable. I don't want him coming for a meeting and seeing a new Lexus in the driveway!"

Both couples timed their refinancing well, taking advantage of this year's low rates and lending flexibility. Not only are they spending hundreds less each month, they turned car and credit card payments into a tax-deductible home loan.

Now comes the hard part. "This is the beginning of their effort to get rid of debt, not the end," says Todd Huettner, president of Huettner Capital, a mortgage brokerage specializing in debt consolidation. Whether or not refinancing their debt proves a smart move may depend on whether they take the next steps:

  • Prepare a detailed cash flow analysis. Where is your money going and what are you putting on credit cards? Estimate your average monthly expenditure in all areas. Track spending carefully for three months. Figure out ways to cut back, then set a target and stick to it.
  • Put credit cards in a safe deposit box. To reprogram the charge habit, don't buy anything you can't pay for upfront for at least six months. "I wouldn't advise cutting cards up," says White. "With the current credit situation, people may not be able to replace them later."
  • Start retirement and emergency funds and contribute monthly. The McWeeneys have a good start with the $20,000 extra they took out, but Huettner warns that fund will vanish if they don't feed it. "Saving for retirement and emergencies are line items, the first two things in your budget after taxes," Huettner says. "Then factor in food, shelter, etc. Most people think they'll just save whatever is left over. If that's your approach, there is nothing left over."
  • Hire a financial planner. Follow the McWeeneys' lead and develop a written plan. "A financial crisis is a good opportunity to look at your big picture," says White. "Don't shy away from this because you don't have money right now or don't think you are a big enough client." Sound financial advice will pay for itself.
  • Set a realistic goal for paying off your mortgage. Both couples plan to pay off their mortgages early, but experts say this may not be wise. "That 30-year fixed mortgage becomes an investment, after taxes, of close to 4 percent," says Huettner. "You're probably better off putting that money into a savings account or CD. A mortgage is an inflation hedge."

Whether you decide to consolidate debt into a home loan or chip away at it the old-fashioned way, have a plan in place. Cutting back on your lifestyle and changing spending behavior "takes sweat," says Huettner. "It's not fun." White recommends setting up a reward for achieving certain goals, "something you've wanted but haven't been able to afford."

For Gayle McWeeney, it won't be a new Lexus. "That first month with no payments, it sure is tempting to go hog wild," says McWeeney. "Don't. Treat yourself to a nice dinner out and leave it at that."