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Rolling short-term debt into a home mortgage loan, either at the time of home purchase or later.
The Case for Consolidation: Borrowers consolidate in order to reduce their finance costs. Usually, the interest rate on the mortgage is below that on short-term debt, and mortgage interest is also tax-deductible. Borrowers also like the convenience of making fewer payments.
The Case Against Consolidation: When borrowers consolidate, they convert unsecured debt into secured debt. That is the major reason the mortgage interest rate is usually lower. Borrowers who encounter financial distress and fail to pay their unsecured debts lose their good credit but they don't lose their home. By increasing the size of the claim against their home, they increase the risk of losing it.
If consolidation causes the mortgage amount to exceed the property value, borrowers may also lose their mobility. Sale of the property requires that all mortgages be repaid, which means that the seller must come up with enough cash to cover the deficiency. Borrowers in this situation may also have to pass on opportunities for profitable refinance, since it is very difficult to refinance when debt exceeds value.
Consolidation that reduces the borrowers total monthly payments while eliminating their short-term debt may encourage them to build up that debt all over again. This could result in so much debt they never get out from under.
Consolidating Intelligently: To consolidate intelligently, borrowers need to compare their options. Three debt consolidation calculators on my Web site can help you do this. These calculators are designed for three categories of borrowers with non-mortgage debt:
• Those about to purchase a house. Their options are to consoli- date in the new purchase mortgage, or not.
• Those with an existing first mortgage. Their options are to consolidate by refinancing the first mortgage to include the non-mortgage debt, or by taking out a new second, or neither.
• Those with existing first and second mortgages. Their options are to a) consolidate existing non-mortgage debt in a
new (cash-out refinance) first mortgage, leaving the second mortgage as it is; b) consolidate the existing second mortgage
in a new (cash-out refinance) first mortgage, leaving non-mortgage debt as it is; c) consolidate both non-mortgage debt
and the second mortgage in a new (cash-out refinance) first mortgage; d) consolidate existing non-mortgage debt in a new
(cash-out refinance) second mortgage, leaving the first mortgage as it is; and e) do nothing.
The calculators provide two types of information about each option. One is the total monthly payment, which consists of mort-
gage payments, mortgage insurance premiums if any, and non-mortgage debt payments if any. Borrowers on tight budgets must be concerned with the monthly payment, but it should not be the major determinant of their choice. It fails to reflect differences in tax savings or debt reduction as between the options.
The second type of information the calculator provides about all the options is their total cost over a period specified by the user. If the user's time horizon is, say, five years, the total cost of each option is the sum of the monthly payments over five years including lost interest, less the tax savings and reduction in total debt over that period.
Life After Consolidation: Borrowers who consolidate should use any monthly savings to accelerate the pay down of principal on their mortgage(s). Even better is to shorten the term on the new mortgage(s) so that the new payment is close to the old payment.
Unfortunately, many borrowers interpret a payment-reduction consolidation as a license to take on more non-mortgage debt. A few years later, they look to consolidate again. If their house has appreciated enough, they may be able to, but sooner or later they run out of equity. Then they write me letters like this one.
We kept adding to our second mortgage to pay off credit card debt … the rate is now up to 13.75% … we don't have enough equity to break even if we sell ... we feel trapped.
They trapped themselves. Don't let it happen to you.