Is Your 4% Mortgage Actually Costing You Money?
If you can count yourself as part of the lucky group of homeowners who secured a 4% (or better) interest rate during the covid crisis – I think I know how you feel… you won! While it feels great to see that now apparently extinct rate on your statement each month – is it really working to better your cash flow now?
Let’s not kid ourselves – if you have your financial house in order and aren’t carrying any credit card debt – you shouldn’t touch that rate. On the other hand, if you are carrying credit card debt at 24% then it might be worth revisiting how much that super low mortgage rate might actually be holding you back financially.
The Math: The True Cost of the Status Quo
It’s tough to consider giving up that great rate on your mortgage that, by my own acknowledgement, isn’t available now and may never be available again. The thing is though that if you were to consider the full financing picture of carrying credit card debt and holding onto your low mortgage rate you could be significantly impacting your monthly cash flow.
Let’s break it down with an example:
$300,000 mortgage at 4%
$40,000 in credit card debt at 24%
At first glance – still tough to part with that great rate on your mortgage but it’s costing you.
The current mortgage only costs you $1,432.25 each month in principal and interest whereas the credit card debt is likely costing you between $800 - $1,200 in minimum payments. The additional challenge with the credit card debt is that minimum monthly payment is unlikely to put a dent in your credit card balance.
How a Refinance Can Help
It’s not an easy thing psychologically to go from a 4% to a 6.75% interest rate for anyone. It could feel like you are going backwards financially but the math bears out a different story.
If you were to combine your existing $300,000 mortgage and $40,000 in credit card debt into a new mortgage and we assume that closing costs are about $5,000 you would be looking at a new mortgage payment of $2,237.66.
That would represent a monthly increase in your cash flow of as much as $395 based on our example.
Looking at it from another perspective – if you applied that $395 monthly savings towards your new mortgage you could pay it off in under 20 years.
What about a HELOC?
Perhaps the previous math was unconvincing, and you really don’t want to part with your 4% interest rate, no worries we have a solution for that too. A Home Equity Line of Credit or HELOC may be a perfect way to get some cash flow relief and still hold onto that great rate on your first mortgage.
If you were to take out a HELOC for $40,000 at a 9% interest rate you could see your cash flow improve by up to $1,100 each month versus what you are paying now on credit cards.
A potential pitfall may be that with most HELOCs the initial draw period, the time in which you can borrow against any available credit, usually only requires an interest only payment which helps to make the cash flow look better but comes with some consequences if not properly managed. You could potentially make interest only payments for the first 10 years and still be stuck with the same $40,000 balance that you had when you began if you don’t make additional voluntary principal payments. There is also the strong possibility that your HELOC interest rate is variable and that brings a level of uncertainty to the equation.
What about a fixed rate second mortgage?
If you don’t love the idea of a HELOC and really want to keep your first mortgage rate, then a fixed rate second mortgage might be a great compromise.
With a fixed rate second mortgage you could potentially refinance your $40,000 in credit card debt into a fixed rate 2nd mortgage. If we assume that you could get a fixed rate second mortgage at a 10% interest rate and a 20-year term you could see monthly cashflow improvement of up to $815.
The advantage of a fixed rate second to a HELOC is really in the confidence in the payment moving forward. Unlike the variable rate of HELOCs with a fixed rate second mortgage you know what to expect and can budget with more confidence.
The Truth About All Debt Consolidation
It would be a disservice not to address the reasons for the credit card debt accumulating in looking for solutions to make the monthly payments a little more comfortable. Whether you decide to refinance your first mortgage, take out a HELOC, or secure a fixed rate 2nd mortgage you are still just moving the debt around and it will still need to be paid off. It’s important in all scenarios to really have a heart to heart about where the monthly budget is and how the credit card debt piled up.
Worst case scenario would be to act to consolidate your credit cards with one of these solutions and then find yourself in a similar situation in a few years. A hard look at your monthly income versus expenses can be helpful in not only picking the right solution today but to ensure it serves your future too.
So Which Solution is Best?
This question isn’t as cut and dry as it may appear. The HELOC provides the potential for the most cash flow relief but comes with the greatest risk whereas giving up that great 4% interest rate for a 6.75% cash out refinance may seem silly but could leave you debt free 10 years earlier than you would have otherwise.
It’s really advantageous to have a conversation with a trusted local mortgage professional and look at all options before deciding on how best to structure your financing. Regardless of which route you choose – at least you know if keeping that 4% is in your best interest.
