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.
For example, if you plow the extra $410 into the mortgage payment, the balance will drop to $358,575 at the end of five years. This is $773 less than the balance would be if you kept the car loan and refinanced just the existing mortgage balance.
There are other things you might want to do with the extra $410. Perhaps it should go into a tax-deferred retirement account or be used to build a college fund for the children.
Here’s the bottom line: Financing a short-term asset with long-term borrowing requires that you have a feasible plan with the increased cash flow. If you are likely to fritter away the money, you might want to keep the car loan, but if you can discipline yourself to at least put the money into the mortgage balance, you’ll be ahead almost $1,000 in 60 months.
• Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@pmcmortgage.com).
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