Q:My wife and I are looking into refinancing our fixed-rate mortgage from
our current rate of 6.75 percent to a new rate
of 6 percent.
We have two auto loans that total $30,000, and I would like to roll these into the refinancing because it would save us more than $400 per month. Both loans carry an interest rate
of 7 percent.
My wife thinks we should keep the auto loans even though the rate is higher because rolling them into the mortgage would mean they wouldn’t be paid off until well after the useful life of the vehicles.
I don’t think it matters because it makes financial sense to lower the rate and make the interest tax deductible. Who’s right?
A: You’re both right. On the one hand, converting $30,000 in borrowed funds from a 7 percent interest rate that’s not tax deductible to 6 percent, tax-deductible interest makes financial sense. Let’s illustrate using simple interest.
Simple interest on a $30,000 loan at 7 percent totals $2,100 per year. At 6 percent, the annual interest totals $1,800.
Since the $1,800 is tax deductible, we can shave perhaps 25 percent off, making the after-tax interest cost $1,350.
Compare $1,350 to $2,100, and we see that there’s a $750 annual savings.
So yes, you are correct. Converting the $30,000 into cheaper, tax deductible mortgage money is a good thing.
However, your wife is also correct. I assume the auto loans carry a five-year term, and $30,000 amortized over five years results in a principle and interest (P&I) payment of $594 per month. This is probably close to the sum of you two car-loan payments.
If we take $30,000 and amortize the loan over 30 years at 6 percent, the P&I payment drops to $180 per month. This explains your $400 drop in payment — $414 in this example. At the end of five years, the $30,000 balance drops to $27,916. While your monthly payment drops significantly, your balance does not.
Meanwhile, your vehicles will eventually need to be replaced, long before the money borrowed to purchase them is paid off. This is why your wife is correct. You don’t want to end up with more debt when you need to purchase new vehicles.
The solution is to ensure that you properly invest the difference in the monthly payment. Without going into the details, the trick is to invest the $414 monthly difference to earn an annual return that exceeds the after-tax cost of the mortgage.
To keep things simple, a 6 percent tax-deductible rate, using a 25 percent tax rate, results in a true cost of 4.50 percent (6 x .75).
While the $30,000 loan balance may only drop to $27,916 after five years on a 30-year amortization, investing the $414 that earns a compounded return in excess of 4.50 percent would mean that the balance would grow in excess of $27,916 after five years.
If you squander away the monthly difference, you will be in worse financial shape five years from now. My advice is to sit down with your wife and determine if you are financially disciplined enough to wisely save and invest the $414 payment difference.
The answer to that question will answer the question of whether you should roll your auto loans into your mortgage.
Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@pmcmortgage.com).
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