Loan costs drive plan to refinance

Q: I have a 6.75 percent, 30-year, fixed-rate mortgage with a balance of $385,000. According to your recent columns, I should be able to refinance to a lower rate with no points or closing costs. This is something we are going to do. My wife and I were wondering if we should roll in our five-year, $30,000 car loan, which we just took out. The rate is 7 percent. Is there any reason why we shouldn’t consolidate both loans? Our home is worth well over $500,000.

A: You are correct in that refinancing your current mortgage is a no-brainer. You should be able to find a no-point, no-closing-cost 30-year mortgage at about 6.25 percent. Shaving ½ percent off your mortgage rate makes plenty of sense if there are no sunken costs associated with the transaction.

Now let’s talk about rolling in your car loan. From a pure financial perspective, taking a $35,000 loan with an interest rate of 7 percent that’s not tax deductible and converting it to a tax deductible rate of about 6.25 percent makes sense.

It’s just like having $30,000 and investing it at 7 percent instead of 6.25 percent. A simple rule of financial planning is to strive to minimize your borrowing costs and maximize your return on investment.

So, yes, from a financial perspective, it makes sense to lower the interest cost on a $30,000 debt. Does this mean you should roll in the car loan?

It depends.

Unless you make extra principal payments each month, you will be converting a five-year loan into a 30-year loan. You borrowed $30,000 to purchase a vehicle that will last, say, seven years. Paying off the $30,000 over a 30-year period means the asset you purchased will be gone long before the debt is retired.

In other words, financing a short-term asset that depreciates over time with long-term financing may not be wise. Even though the interest rate drops from 7 percent to 6.25 percent, the overall interest costs will be significantly higher if the loan is spread out over 30 years. Let’s run some numbers.

Refinancing a $385,000 loan from 6.75 percent to 6.25 percent will drop the payment by about $126 — from $2,497 to $2,371. As I said, if there are no closing costs, this makes plenty of sense.

The payment on your $30,000 auto loan should be about $594 per month. Paying this loan off and increasing your mortgage to $415,000 would create a principal and interest (P&I) payment of $2,555 per month.

Rolling in the auto loan would lower your payments considerably. Instead of paying $594 for the car and $2,371 for the mortgage, you’d have one mortgage payment of $2,555, saving you $410 per month.

The problem is that you aren’t actually “saving” money because the car loan won’t be paid off in five years. I see from my calculator that your mortgage balance at the end of five years will be $387,349. If you decide to keep the car loan, the balance will be zero in five years. The $385,000 mortgage will drop to $359,348.

Rolling in the car loan and making the regular payments will save you $410 per month, but your total debt will be $28,001 more ($387,349 - $359,348).

Does this make sense? As I said, it depends.

If you are not financially disciplined and see yourself frivolously spending the extra $410, it might be a good idea to keep the car loan because it will force you to reduce your debt. However, if you have a financial plan to do something with the extra $410, your net worth will increase at the end of five years.

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