Beware the Refi Treadmill

Lower interest rate, cash back to pay off credit cards or other high interest debt; what could be better, right? Maybe right or maybe wrong. Refinancing your home can make a lot of sense if:

  1. You have a high interest rate and interest rates have gone down across the board
  2. You have improved your credit score and could get a better interest rate
  3. You now have 20% equity in your home and can get rid of PMI
  4. You haven’t been in your current mortgage that long, you plan to stay in your current home for at least about 10 years and you’re at least about 20 years away from retirement

It is less attractive to refi if you are doing it because your household may go bankrupt if you do not clear some high interest debt. Even though getting cash out of your home equity (the amount of your home you own free and clear) to pay debts will certainly make you feel a little calmer in the short term, it MAY not be better in the long term and here’s why:

  1. You start the mortgage clock ticking again, meaning you are again 30 or 15 years away from being mortgage free, which matters a lot if you’re in your 40s or 50s (or 60s) and looking toward a debt-free retirement.
  2. You could have a higher interest rate on your mortgage itself, because if you have a lot of debt (credit cards) your credit score might be lower and your rate could go up.
  3. You could have a higher interest rate simply because you are taking cash out of your home equity. Banks do not like that.
  4. Chances are your increased monthly payment for your new mortgage (or mortgage and home equity line of credit combined) is about the same as your monthly payment on your credit cards especially if you were trying to pay more than the minimums, which means you do not have any more cash each month that before, You need to change your habits.
  5. Although it cleans up lots of messy and expensive credit card debt, it does not solve the underlying issue: YOU ARE SPENDING TOO MUCH.

Refinancing your home to pay credit card debt will only solve your financial issues for the MOMENT you pay the credit cards off. One time only to right your ship. You cannot and should not take cash out of your home multiple times because you cannot control your spending (what I mean by “treadmill”). You erode your savings (equity in your home) and over the long run (30 years of a mortgage) probably pay more interest than the 25% credit card interest depending on the amount of debt you have.

You could pay a lower interest rate for your mortgage compared to your credit cards, but the amount of cash flow in your home does not change usually because your mortgage payment goes up. If you do not cut your spending (in some cases, drastically) each month, you will be one car repair, root canal, flooded basement away from financial ruin again.

The best protection against financial ruin due to credit card debt is to consistently spend less than you earn. The refi is meaningless without cutting spending and having a rainy day fund for car repairs, etc. The good news is it could be a chance to hit the ‘reset’ button on your spending habits. Take the opportunity to change your ways and spend less than you earn.