For homeowners who have mortgages along with other debts at higher interest rates, it can be advantageous to consolidate these debts into their mortgage. This approach offers two main benefits that can significantly improve their financial situation.
The first benefit is interest savings, which is apparent to most people. By incorporating higher interest debts into their mortgage, borrowers can take advantage of the lower mortgage interest rates, resulting in substantial interest savings over time. However, the second benefit, managing cash flow, is equally important and often overlooked.
The ability to consolidate other debts into the mortgage comes from not only paying down the mortgage principal over time but also from the appreciation of the property’s value. While property values may not necessarily increase every year and may experience fluctuations due to market conditions, real estate tends to appreciate nicely over the long term. Given the limited supply of prime real estate, coupled with population and income growth, this trend is expected to continue indefinitely.
Home equity, which represents the market value of the property minus the outstanding mortgage amount, plays a crucial role in this process. While homeowners may not be able to add the entire home equity to their mortgage, they can utilize a portion of it to consolidate other debts.
Refinancing a mortgage incurs fees, so it’s not advisable to do it frequently or for small amounts. Instead, it is typically more beneficial to refinance for significant amounts of debt. Homeowners may choose to refinance their mortgage or extend the amortization to lower their monthly payments, creating a surplus that can be used for other purposes.
Ideally, homeowners should consider both options: consolidating higher interest debt and extending the mortgage amortization to increase cash flow while saving on interest payments. By refinancing higher interest debts into the mortgage, they benefit from the lower mortgage rates, which are the most favorable due to the security provided by the property.
Using Home Equity to Reassign Existing Debt
When people obtain a mortgage, they often carry other debts alongside it. Initially, lenders cannot add these debts to the mortgage since they won’t lend more than the property’s value being mortgaged, as that would leave the additional amount unsecured. However, as homeowners build equity in their property over time due to appreciation and mortgage payments, they may have an opportunity to consolidate other debts into their mortgage to potentially save on interest.
To address their other debts, individuals can choose to use part of their down payment, if available, and pay down those debts separately. While this approach works similarly to adding debt to the mortgage, lenders cannot facilitate it during the mortgage’s initial extension.
As time progresses, homeowners accumulate equity in their property, and as their mortgage gets paid down, they may consider consolidating other debts. Some individuals might hesitate to do so due to uncertainty about the potential savings. In such cases, lenders should step in and perform calculations for their clients, demonstrating how much they could save in interest by incorporating other debts into the mortgage.
However, borrowers should be cautious, as these calculations might not always be accurate. Some lenders may portray increased cash flow as savings, which can be misleading. For example, if a car payment of $400 per month has three years left, and the borrower extends the amortization over 25 years, the monthly payment for that car loan will decrease significantly, perhaps to $60 per month. This reduction of $340 per month might be presented as savings by some lenders, but it’s crucial to understand that the reduced payment only applies during the amortization period of the other debt, which in this case is three years. Once that period ends, the payments will increase again, and this aspect might not be properly disclosed.
Awareness of these tactics is essential for borrowers, as some representatives might inadvertently present misleading calculations. Borrowers need to understand that the reduction in payments only applies to the amortization period of the other debts, and unless those debts are paid off within that timeframe, their payments will rise once the period ends.
Balancing Interest Savings with Cash Flow
Taking on too much debt can lead to overwhelming cumulative payments. In such cases, refinancing shorter-term debt, like loans, over a longer term, such as with a mortgage, can be a helpful solution and even lead to cost savings.
The primary goal of refinancing in these scenarios is to reduce overall payments, and the longer amortization periods offered by mortgages make them ideal for this purpose. By refinancing debt into a mortgage, borrowers can free up more cash, which can be used to tackle future borrowing needs and make extra payments on the mortgage.
For instance, if someone decides to refinance a car loan, they can aim to pay it off over the original three-year term by making additional payments on the mortgage. This approach allows them to enjoy the reduced interest rate on the car loan while benefiting from lower monthly payments due to the interest savings. The extra cash freed up can then be directed towards paying off the car faster or setting it aside for other financial goals.
However, it’s essential to avoid complacency and not let the debt sit on the mortgage for the entire term without making extra payments. This can lead to paying more interest on the debt over time. Striking the right balance between interest savings and payment flexibility is crucial in such refinancing deals.
When it comes to higher interest debt, like credit card debt, it’s almost always more advantageous to move it to a mortgage. Credit card debt tends to accumulate due to the high interest rates, and refinancing it into a mortgage can result in significant interest savings, even if borrowers don’t make extra payments to pay it off faster.
The Right Way to Approach Mortgage Refinancing
A crucial aspect of managing debt through mortgage refinancing – the importance of striking a balance between building reserve capital and using savings to pay down the refinanced debt effectively.
The ideal approach involves two main objectives: first, building up reserve capital to handle both current and foreseeable future financial obligations, and second, using some of the savings to make periodic extra payments on the mortgage to reduce the refinanced debt in a manner similar to how it would have been paid down if it were not refinanced.
By adopting this strategy, borrowers can benefit from the best of both worlds. They can lower their overall payments and have more control over their finances by strategically allocating their money. Moreover, refinancing higher interest debt into a lower interest mortgage product allows for reduced overall interest payments.
However, it’s essential to avoid overextending credit to the point where unforeseen expenses could lead to additional borrowing beyond one’s ability to manage payments. While refinancing can help address such problems, maintaining a sufficient reserve capital is a smarter approach to comfortably handle unexpected financial needs.
Building savings is crucial, especially for those in the accumulation phase of life who might spend close to or more than their income in the short to medium term. Without adequate savings, one’s financial health is at risk. Refinancing debt through a mortgage can be particularly beneficial as it enables individuals to start saving money and set funds aside for future use, as long as they actively take advantage of this opportunity.
The ultimate goal is to manage finances effectively without having to frequently restructure debt. Overutilizing refinancing options can lead to challenges down the road, where individuals may not be able to add more debt but still require it, resulting in financial difficulties.
