Refinancing with cash-out to pay off high-cost short-term debt is tempting, but if it involves a higher mortgage rate, which in today’s market is very likely, the borrower will probably do better taking out a new second mortgage.

Refinancing in a Rising-Rate/Rising-Property-Value Market
(Last of Three)
June 21, 2018

While rising interest rates have sharply reduced the number of mortgage borrowers who can refinance into a lower rate, rising home prices create opportunities for some borrowers to refinance into mortgages that are less costly in other respects. Previous articles looked at refinancing a mortgage that is burdened by mortgage insurance, or by a second (“piggyback”) mortgage, into a new mortgage that has neither. This article considers a third option, which is to refinance in order to consolidate short-term debts.

This appears to be one of the most attractive options a mortgage borrower may have.  Yet of the three approaches to refinancing considered in this series of articles, this is the trickiest and the easiest to get wrong.  

Multiple Options: Homeowners with one mortgage and high-cost short-term debt can refinance that mortgage with cash-out in an amount sufficient to pay off the short-term debt. (Note: “cash-out” means that the new mortgage amount will be larger than the outstanding balance of the old one). Alternatively, they can take out a new second mortgage to pay off the short-term debt, and leave the first mortgage alone.   

Homeowners who already have 2 mortgages along with short-term debt also have two options:

  • They can refinance the second mortgage with cash-out to consolidate the short-term debt, leaving the first mortgage alone.

  • They can refinance both mortgages into a new first mortgage that also includes the short–term debt.

Note that refinancing the first mortgage alone is not a good option because the first mortgage lender requires the borrower to obtain permission of the second mortgage lender, without which the second mortgage becomes the first mortgage. Getting permission can be a hassle.

Calculators for Assessing Options: I have two calculators on my web site designed to deal with these two situations. These are:

Calculator 1b: Debt Consolidation Calculator For Home Owners With One Mortgage. 

Calculator 1c: Debt Consolidation Calculator For Home Owners With Two Mortgages.

The calculators provide the information about each option that is needed to make the correct decision. This includes the total monthly payment, which consists of mortgage payments, mortgage insurance premiums if any, and non-mortgage debt payments if any. Borrowers on tight budgets must be concerned that the monthly payment be affordable, but it should not be the major determinant of their choice.

The second type of information the calculators provide about all the options is their total cost over a period specified by the user. If the user’s time horizon is, say, 10 years, the total cost of each option is the sum of the monthly payments over 10 years including lost interest, less the tax savings and reduction in total debt over that period.

Minimizing total cost should be the borrower's major objective because cost minimization is the path to early debt retirement. This measure should be used both to determine whether to refinance, and if so, which of the options to adopt.

Avoid Payment Myopia: A single-minded focus on the monthly payment can lead borrowers to a bad decision. As an example, Marie has a $358,788 balance on her 3.5% first mortgage secured by a home now worth $600,000, but she owes $50,000 on credit cards with an average interest charge of 24%. Marie wants to rid herself of the high-cost credit card debt, the question being how best to do it.

With recent appreciation, she now has enough equity in her house to refinance her mortgage with sufficient cash-out to pay off the credit cards, paying 4.5% and 2 points on the new first mortgage. The alternative is a new second mortgage for $50,000 at 7.5% and 2 points, leaving the first mortgage as it is.

From a monthly payment perspective, consolidating the short-term debt by refinancing is more attractive, reducing her total monthly payment from $2796 to $2113. Consolidating in a new second mortgage would result in a total payment of $2153.

From a cost perspective, however, taking a new second mortgage is the better deal. Over the next 10 years, total cost would be $144,000 in the refinance case compared to $117,000 in the second mortgage case. At the end of the 10 years, Marie would owe $38,000 less if she took the second mortgage rather than refinancing the first.

Concluding Comment: The reason that refinancing is not the best solution in this case is that the interest rate on a new first mortgage is higher than the rate on the existing mortgage. As a result, in order to reduce the rate on $50,000 of debt by refinancing, Marie would be obliged to increase the rate on $358,788 of debt.

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