Consolidate Your Debt with a New Purchase Mortgage

Some home buyers try to kill two birds with one stone by consolidating their debts in a new purchase mortgage. Usually this is not a good idea, as in the case illustrated below from our fictitious Mr. Jones.

“I have $30,000 in cash for a down payment on the $300,000 house I am purchasing. I also have a $15,000 of credit card debt at 12% that I would lover to get rid of. The loan officer says I can roll in into a new $285,000 30-year mortgage at 6%. This cuts the rate on my credit card debt in half and makes it deductible. Further, my total monthly payment would be only $1891, compares to $2,051 if I didn’t consolidate and took a $270,000 loan. Is there any reason I shouldn’t consolidate?” – Sincerely, Mr. Jones

Yes, appearances to the contrary notwithstanding, this consolidation will only make Mr. Jones poorer.

True, the rte on the mortgage is well below the rate on his credit card debt, and the mortgage inters is tax deductible as well. However, if Mr. Jones increases the size of his loan from $270,000 to $285,000, he will increase either the mortgage insurance premium or the interest rate on the purchase mortgage. It take only ¼%rate increase on the $285,000 to offset the savings from a 6% rate reduction (including the shift to deductibility) on $15,000 of credit card debt. Consolidation would also reduce Mr. Jones’ total monthly payment, but that is mainly because he would be paying down his debt more slowly. If he consolidates, he will owe $260,484 at the end of 6 years, which may be his best guess as to how long he will be in his new house. If he doesn’t consolidate, he will owe only $246,774.

These numbers and the others cited below are drawn from a simple calculator used to determine Mr. Jone’s total costs over 6 years if he:
a. Doesn’t consolidate, which means he takes the first mortgage for $270,000 and leaves the non-mortgage debt as is;
b. Consolidates in the first mortgage, which means that he takes the first mortgage for $285,000 and pays off the non-mortgage debt; and
c. Consolidates in a second mortgage, which means that he takes out the first mortgage for $270,000 to buy the house, and afterwards he takes a second mortgage for $15,000 to pay off the non-mortgage debt.

For example, here are the terms at which Mr. Jones can borrow under all three options. The $270,000 and the $ 285,000 first mortgages are both “no-cost” at 6% for 30 years- they differ only in the mortgage insurance premium. The $15,000 second mortgage is also “no- cost” at 10% for 15 years; Mr. Jones also happens to be in the 25% tax bracket and wants interest loss to be calculated at 2%.

The cost can be measured as total monthly payments over the proposed 6- year period; plus the lost interest on those payments (interest that could have been earned but wasn’t);
Minus the tax savings on interest, including the interest earnings on tax savings; minus the reduction in debt balances over the 6 years.

Mr. Jones’s costs are $89,904 without consolidation, $92,311 with consolidation into the first mortgage, and $89,523 with consolidation into the second mortgage. While consolidation in the first mortgage rids him of the high payments on the non- mortgage debt and increases his tax savings, these are more than offset by higher mortgage insurance premiums and smaller debt reduction. Consolidation with the 10% second mortgage, on the other hand, turns out to be slightly profitable.

In making decisions about debt consolidation, borrowers generally make two kinds of mistakes. One is to base the decision on the monthly payment, ignoring what happens to the loan balance. This mistake pervades many financial decisions.

The second mistake is for borrowers to decide in advance that they are going to consolidate, and only price mortgages that allow it. Their focus is the cost difference between the non-mortgage debt and the mortgage what that would consolidate that debt. They ignore the fact that if they don’t consolidate, their mortgage would be smaller and therefore less costly.

Learn to use your calculator! One benefit of using it to determine the overall costs and potential savings is the discipline it imposes. It should force you to consider all the options, and to collect all the data required to assess each option.

Unfortunately, some borrowers are allergic to calculators and need a rule of thumb. Unfortunately, the common one that says “consolidation is profitable if the rate on the first mortgage is below the rate on the non-mortgage debt” is wrong most of the time. Replace it with “consolidation is profitable if the rate on the first mortgage is below the rate on non-mortgage debt, and if the rate or mortgage insurance premium on the first mortgage is no higher with consolidation than without.” This one will be right most of the time.