Reducing Payments by $200?

by Gary Foreman


Dear Gary,
Recently a friend told me how they refinanced their home and consolidated the automobile loans into their home loan. She says they have an extra $200 each month now. Is this the way to go? We are planning to sell our home in the next two to three years. Our friends who did this just moved into their home a year or two ago.
Thanks,
Michelle

Wow, that's a lot of money! If someone offered me $200 a month, I'd take a look at it, too! And spurred on by television ads promising that you can save by borrowing your home equity many people are considering this type of loan.

To understand what happens we'll need to learn a little about borrowing money. Let's call it Borrowing 101.

We'll begin with an example that's familiar to most people, the simple auto loan. You borrow a specific amount of money (say $20,000) at a fixed rate of interest and will be making payment for a set period of time (2, 3, 4 or 5 years). When you've made all the payments the car belongs to you. If you fall behind in your payments they come and repossess the car. The reason that they can take the car is that you have made a "secured loan." That means that the car is acting as collateral for the loan.

Your home mortgage works pretty much the same way. Your house guarantees the loan. There are a couple of differences. First, the term or length of the loan is much longer, typically 15 or 30 years. Also, the interest rate on the loan is less than that for an auto. That's because, unlike a car, your home doesn't lose value or depreciate. There's less risk for the lender so you pay a lower rate of interest.

A third type of borrowing occurs with your credit card. Unlike your home or car, when you pull out your credit card you're making an "unsecured loan." That means that if you fall behind in your MasterCard payment, no one will come and take back your VCR or the business lunch you had last month! Because there's nothing to repossess, the lender gets a higher rate of interest.

One other difference separates the credit card from your home or auto purchase. That's the fact that the credit card is "revolving debt." That means that you're continually paying off and adding to the balance due. It's not really expected that you pay off your credit card each month. You can, but the lender is content if you just keep making the minimum payment each month. That way they keep collecting interest.

To summarize Borrowing 101, your monthly payment is lower for a longer loan, and the interest rate will be lower for an secured loan. So if you want to get the lowest possible monthly payment, you'll borrow money for the longest period of time on a secured loan.

That's where your house comes into the picture. Home equity loans and mortgages are guaranteed by your house and are a long-term loan. Many home equity loans have no maturity date so they go on forever! Armed with this information, let's see if we can't answer Michelle's question. We'll have to make up some numbers to illustrate the point. You can plug in your numbers to see what your situation looks like.

To simplify our example, for right now we'll assume that Michelle is consolidating just her credit card bills and not a car loan, too. How much could she save if she refinanced her house and included her credit card debt? To find that out you'll need to know what the interest rates are on both the credit card account and the new refinanced home mortgage.

Suppose the credit card was at 16% and the mortgage was at 7%. She'd be saving 9% in interest payments. Further suppose that she owed $8,000. That would mean that she'd save $720 per year ($8,000 x .09 = $720) or $60 per month.

Michelle's payment will change by a little less than the $60 per month. That's because her new house payment will include some principal repayment each month that's not included in the revolving credit card account.

We run into a similar problem when shifting money from a car loan to a refinanced mortgage. Your car loan only runs a few years, while the mortgage runs 30 years. Obviously, your payment will be less if you're paying back the money over many more years. But it's not an easy calculation to make without a financial function calculator. Fortunately, they're available for about $20 and you can learn to use it for this purpose in a matter of minutes.

So should Michelle consider consolidating her debt into a refinanced mortgage? She can compare the interest rates and calculate how much she'd be saving in interest expense. Because Michelle plans on moving in a few years, she needs to be very careful about any fees associated with the refinancing. She might find that the fees outweigh the interest savings.

A word of caution is appropriate. Do not make the decision solely on how much you'll save on minimum monthly payments. You're comparing apples to oranges. Moving money from a car loan is the same as agreeing to have car payments for 30 years! If the debt comes from credit cards, you've taken an unsecured loan and put your house up as a guarantee that you won't miss your payments.

Consolidating your debts can be a good idea if certain things are true. You need to save on interest expense. There should be absolute certainty in your mind that you won't fall behind in your payments. And, you must have the self-discipline to keep from spending the "extra money" that the lower payments will make available. It would be wise to use that money to prepay your mortgage or invest it in an IRA.

The ads on television make it sound so easy. They take all your debts. You don't need to worry about understanding what's happening except that you'll have lower payments. Just sign here. Warning bells should be going off in your head. Any contract that you don't understand is too dangerous to sign.

But, if you do understand the transaction, and you know how much you'll save and how much you'll spend, it can be an appropriate method for saving interest expense. Thanks to Michelle for giving us the opportunity to explore debt consolidation loans.


Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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