By Janet Arrowood

The pitches are everywhere for consumers to refinance now. Debt consolidation, as part of a written, well-managed financial program, can be an excellent plan. I can’t argue with the theory of replacing high-interest, nondeductible obligations with lower-interest, (possibly) tax-deductible payments—I did it myself. Unfortunately for many people, the underlying factors that led to debt or cash flow problems in the first place have not changed. What are some good and bad reasons for refinancing? What are some of the worst pitfalls and misconceptions?

Good reasons
There are several good reasons to refinance. Perhaps the most justifiable one is to save money on house payments. In simple terms, if the cost—whether paid up front or put in the loan—divided by the number of months the client plans to stay in the house is less than the difference between the old and new mortgage payments, refinancing usually makes sense. In other words, if the cost for the new loan is $6,000 and your client plans to stay in the home for at least 60 months, the monthly cost is $100. If the old mortgage was $900 per month and the new mortgage is $750 per month, the reduction is $150. Since $100 is less than $150, this is probably a good refinance. If your client plans to stay in the house for only 30 months, the monthly cost is $200, and the monthly savings is only $150. This is not a good deal.

Sometimes your clients need cash they can’t get anywhere but from their home equity, either by refinancing or taking a second mortgage or a home equity line of credit. Also, they may have nondeductible debt, such as a car loan or credit card interest.

Sometimes your clients need cash they can’t get anywhere but from their home equity.

Bad reasons
In the late 1990s and in early 2000, people took up day trading and looked for sources of cash to fund and cover their trades. Many turned to the equity in their homes. They refinanced with 110 percent to 125 percent loans so they actually owed far more on their homes than the homes were worth. Then the stock market bubble broke, and they were unable to pay their mortgages. To make matters worse, they still owed the money they borrowed, even if their homes sold for less than the loans against them.

Saving money on house payments is great but only if your client will be in the home long enough to recoup the costs associated with obtaining a new loan. Borrowing to pay off credit cards, car loans or other revolving debt can be a great idea, but only if your client has a written plan in place, including a repayment schedule that includes more than interest-only. If the underlying problems that caused the debts to mount are not addressed and eliminated, your clients will run into the same problems as when a lower-rate credit card is used to pay off a higher-rate card. But this time they are gambling with their homes and their equity. In all cases (equity line, higher cash-out mortgage, or new credit cards), clients are risking their credit-worthiness and can lose everything.

The examples I’ve given about refinancing that make sense are simplistic. In reality, since costs added to the mortgage also add to the total loan cost (in the form of more interest payments or reduced equity), the break-even points are a bit higher than simple math would indicate.

Another area that can cause trouble is adjustable rate mortgages (ARMs). There are different indexes used to calculate how much a mortgage payment can rise after the initial lock-in period. Some mortgages begin adjusting after the first year, and can go up 2 percent in one year and 6 percent over the lifetime of the loan. Going from a 6 percent to a 12 percent mortgage in three years will cause quite a case of sticker shock. If your client plans to be in the home for more than five years, an ARM is almost never a good idea. Rates are so low now that it is unlikely that the adjustable rate will go down after the initial lock-in period

Clients take out new mortgages, seconds or home equity lines of credit and then use the cash to pay off a car loan, other nondeductible loans or credit card bills. This can be a good thing, but only if there is a realistic repayment schedule that doesn’t make the long-term cost more than the original loan. For example, if a client takes out a home equity line of credit at 4.5 percent, pays off a 6.5 percent car loan and makes interest-only payments, the ending cost will be much higher than the original loan, even with the interest-tax deduction. And at the end of the loan period (or when the house is sold), the original balance on the car loan will still be due. Avoiding refinancing pitfalls can be straightforward but only within the framework of a plan. You, your clients and mortgage brokers can work together to enhance your clients’ bottom line.

Janet Arrowood is the managing director of The Write Source, Inc., an Evergreen, Colo., financial writing and training firm. You can reach her at thewritesource@earthlink.net.

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