When it makes sense to bet the house
January 23, 2014
Refinancing your mortgage loan can help make your debts more manageable -- and it can also increase your risk of losing your home to foreclosure. Any time you use your home as a security for a loan, you are essentially betting your house on your ability to repay.
Mortgage debt has certain advantages over other forms of debt. It typically carries a lower interest rate, and that interest is often tax-deductible. So, in theory it makes sense to funnel as much of your debt burden as possible into a mortgage, which you can accomplish by refinancing. The catch is that this debt is secured by your home, so you only want to ramp up mortgage debt if you are absolutely certain of being able to keep up with the payments.
Making the call
Americans have effectively been trading mortgage debt for more expensive forms of borrowing in recent years. Consumers have paid off a trillion dollars in mortgage debt since 2009, but since that time they have also accumulated another half a trillion in other forms of debt. In at least some of those situations, people probably would have been better off choosing the cheaper mortgage debt over more expensive borrowing, such as credit card debt and personal loans.
Here are some examples of when it does and does not make sense to increase your mortgage debt while refinancing:
- If you are having trouble making your monthly mortgage payments, refinancing can help. If you are a few years into a mortgage and struggling to make your monthly payments, refinancing into a new 30-year mortgage will spread your remaining balance out more and make your payments more manageable (assuming mortgage rates have not risen significantly). Stretching your loan out will probably mean paying more interest over the life of the loan, but that's a better alternative than foreclosure.
- Refinancing should not be a gateway to more spending. Spreading your debt out in the manner described above can be a necessary evil, but it should not be used to free up money in your budget for more spending.
- Cash-out refinancing can be used to reinvest in your home. Tapping into equity makes sense if you are reinvesting in necessary maintenance and repairs, or in improvements that will add value to the home.
- Trading equity for discretionary spending is a bad idea. On the other hand, you should not sacrifice equity for luxuries you don't really need, like a vacation or new television.
- A mortgage can be used to retire high-interest credit card debt. Credit card interest rates are about 8 percentage points higher than mortgage rates today, so if you can use a cash-out refinancing or home-equity loan to retire some credit card debt, you could save a bundle on interest expenses.
- Shifting debt to a mortgage only makes sense if you are confident you can repay it. The above strategy only makes sense if it won't make your mortgage payments unmanageable and put you at the risk of default. It also should be used as a one-time way to retire credit card debt, not as a way to refuel those cards for more borrowing.
Ultimately, refinancing is like most financial tools -- it is neither inherently good nor bad, and the wisdom of using it depends entirely on how and why you do it.