Many people do a debt consolidation refinance because it enables them to lower their monthly debt expenses. In addition to your monthly debt payments, borrowers should also consider total interest expense when evaluating if you should refinance your mortgage to consolidate high cost debt. Unless you lower your mortgage rate or reduce your loan term when you refinance, you will pay more in total interest over your combined existing and new mortgage, even if you reduce your total debt payments by refinancing. This is because you should add the interest you have already paid on your existing mortgage to the interest you will pay on your new loan to calculate the total interest expense over the life of the combined mortgages. For example, if you are five years into a 30 year mortgage and you refinance it with another 30 year mortgage, it takes you 35 years to pay-off your original mortgage so it essentially becomes a 35 year loan. The longer your mortgage, the more interest expense you pay.
Total interest expense is also an important factor to consider when you evaluate what debt to consolidate when you refinance. When you consolidate loans into your mortgage balance, that loan effectively becomes the same length as your mortgage. For example, if you consolidate a $10,000 car loan with a seven year loan term into a new 30 year mortgage, the car loan that you would have paid off in seven years now takes 30 years to pay off. Extending the length of a loan by 23 years significantly increases your total interest expense for that loan even if you are able to reduce the interest rate with a debt consolidation refinance. In short, the longer it takes you to repay a loan, the more interest you pay to the lender.
In this case, even if the mortgage rate is lower than the interest rate for the car loan, say 5% as compared to 7%, you end up paying a lot more money for the car loan in the long run by extending its term, even if you reduce the rate you pay on the loan and your total monthly debt expense in the near term. For some borrowers, not consolidating debt when you refinance makes more financial sense even if your debt payments are higher for a number of years.
The example below illustrates that even when you eliminate credit card debt with a high interest rate, you pay more in total interest expense over the life of your existing and new mortgage with a debt consolidation refinance unless you lower the mortgage rate or reduce the length of your new mortgage. In the example, the borrower is five years into his or her original $380,000 30 year fixed rate mortgage with a 5.000% interest rate and $2,040 monthly payment. The borrower also has $20,000 in credit card debt with an interest rate of 12.0% and a $240 monthly payment. We evaluate three scenarios for the borrower:
For each case we examine the combined monthly mortgage and credit card payment and total interest expense over the life of the loans. In cases two and three where the borrower refinances, we add the interest expense the borrower has already paid over the first five years of the existing mortgage to the interest expense the borrower pays over the life of the new mortgage to calculate total interest expense for the combined mortgages. By refinancing and not reducing the mortgage balance or term, you are effectively extending the length of the original mortgage so you should consider the interest expense for both loans.
In Case 2, where borrower refinances and consolidates debt but the mortgage rate is unchanged, the borrower reduces his or her combined monthly mortgage and credit card payment by $240 but pays $44,949 more in total interest over the life of the combined mortgages as compared to not refinancing. In this scenario the borrower pays more in total interest expense even though the expensive credit card debt was paid off because the borrower was not able to reduce the mortgage rate by refinancing.
In Case 3 where the borrower does a debt consolidation refinance at a lower mortgage rate, the borrower reduces his or her combined monthly mortgage and credit card payment by $465 and pays $36,051 less in total interest over the life of the combined mortgages as compared to not refinancing. This is because the borrower was able to both consolidate debt and reduce the mortgage rate by refinancing.
If your primary goal is to lower your total monthly debt expense then both refinancing scenarios make sense. If you are focused on reducing your debt payments and total interest expense then you should only refinance if you can lower your interest rate or shorten your mortgage term
This example demonstrates the importance of considering total interest expense when evaluating the financial benefits of a debt consolidation refinance. While refinancing can save you money in the short term, you may end up paying much more in the long term depending on your new mortgage rate and the interest rate and length of the loans you consolidate.
“What is the Total Interest Percentage (TIP) on a mortgage?” CFPB. Consumer Financial Protection Bureau, September 13 2017. Web.About the author