November 22, 2004, Revised July 18, 2007, September 4, 2007

Consolidation is Not Possible Without a Down Payment

House purchasers consolidating non-mortgage debt in a mortgage must make down payments large enough that their loan meets the maximum ratio of loan to property value after the consolidation.

For example, assume the house price is $100,000, the borrower puts $10,000 down, and consolidates $5,000 of debt. The consolidation increases the loan from $90,000 to $95,000, and the ratio of loan to value from 90% to 95%. If a 95% loan-to-value ratio remains within the lenders underwriting requirements, the consolidation will work, but if 90% is the maximum allowable ratio, it won't.

That a consolidation is possible does not mean that it is profitable; in most cases it isn't, because the increase in loan-to-value ratio raises the cost, though appearances can be deceiving.

With Debt Consolidation, Appearances Can Be Deceiving

Consolidating credit card debts in a new purchase mortgage may lower total payments, but in most cases it will make the purchaser poorer. This is true in the case described below.

"I have $30,000 in cash for a down payment on the $300,000 house I am purchasing. I also have $15,000 of credit card debt at 12% that I would love to get rid of. The loan officer says I can roll it into a new $285,000 30-year mortgage at 6%. This cuts the rate on my credit card debt in half and makes it deductible. Further, my total monthly payment would be only $1891, compared to $2051 if I didn’t consolidate and took a $270,000 loan. Is there any reason I shouldn’t consolidate?"

Consolidation looks attractive in this case because the rate on the mortgage is well below the rate on the credit card debt, and mortgage interest is tax deductible as well. However, the increase in loan size from $270,000 to $285,000 increases either the mortgage insurance premium or the interest rate on the purchase mortgage. It takes only a ¼% rate increase on $285,000 to offset the savings from a 6% rate reduction (including the shift to deductibility) on $15,000 of credit card debt.

Consolidation reduces the total monthly payment in this case mainly because of lower debt repayment. With consolidation, the borrower will owe $260,484 at the end of 6 years, which is her best guess as to how long she will be in the new house. If she doesn’t consolidate, she will owe only $246,774.

Using a Debt Consolidation Calculator

These numbers and the others cited below are drawn from calculator 1a, Debt Consolidation in a Purchase Mortgage. I used this calculator to determine total costs over 6 years if the buyer: a. Doesn’t consolidate, which means she takes the first mortgage for $270,000 and leaves the non-mortgage debt as is; b. Consolidates in the first mortgage, which means that she takes the first mortgage for $285,000 and pays off the non-mortgage debt; and c. Consolidates in a second mortgage, which means that she takes out the first mortgage for $270,000 to buy the house, and afterwards she takes a second mortgage for $15,000 to pay off the non-mortgage debt.

Based on information provided by the buyer, I entered the terms at which she can borrow under all three options. The $270,000 and the $285,000 first mortgages are both no-cost at 6% for 30 years -- they differ only in the mortgage insurance premium, which the calculator knows. The $15,000 second mortgage is also no-cost at 10% for 15 years. She is in the 25% tax bracket and wants interest loss to be calculated at 2%.

The calculator measures cost as total monthly payments over the 6-year period; plus the lost interest on those payments (interest that could have been earned but wasn’t); minus the tax savings on interest, including the interest earnings on tax savings; minus the reduction in debt balances over the 6 years.

The costs are $89,904 without consolidation, $92,311 with consolidation into the first mortgage, and $89,523 with consolidation into the second mortgage. While consolidation in the first mortgage eliminates the high payments on the non-mortgage debt and increases tax savings, these are more than offset by higher mortgage insurance premiums and smaller debt reduction. Consolidation with the 10% second mortgage, on the other hand, turns out to be slightly profitable.

Common Mistakes in Debt Consolidation Decisions

In making decisions about consolidation, borrowers make two kinds of mistakes. One is to base the decision on the monthly payment, ignoring what happens to the loan balance. This mistake pervades many financial decisions.

The second mistake is for borrowers to decide in advance that they are going to consolidate, and only price mortgages that allow it. Their focus is the cost difference between the non-mortgage debt and the mortgage that would consolidate that debt. They ignore the fact that if they don’t consolidate, their mortgage would be smaller and therefore less costly.

One benefit of using a calculator is the discipline it imposes. It forces you to consider all the options, and to collect all the data required to assess each option.

Good and Bad Rules of Thumb About Debt Consolidation

Some borrowers are allergic to calculators and need a rule of thumb. Unfortunately, the common one that says "consolidation is profitable if the rate on the first mortgage is below the rate on non-mortgage debt", is wrong most of the time. Replace it with "consolidation is profitable if the rate on the first mortgage is below the rate on non-mortgage debt, and if the rate or mortgage insurance premium on the first mortgage is no higher with consolidation than without." This one will be right most of the time.