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Consolidating debt within a mortgage: Good idea?

Recently a close friend showed me how she was going to consolidate their high-interest debt into their mortgage to reduce their overall interest rate and free up hundreds of dollars in cash flow every month. Debt consolidations are nothing new, but they only work if the person is not simply looking for a quick fix.

In this particular case, $410 was freed up in monthly cash flow and the refinanced mortgage interest rate was lower. In many situations, however, consolidating debt into a mortgage comes at a cost: You must break your current mortgage and the high-interest debt then gets amortized into the new mortgage balance at a lower interest rate. Your overall debt goes up by a few thousand dollars (the cost to break the term and perhaps paying a CMHC premium on the increased balance on the mortgage), the rate of interest you pay overall goes down, but those high-interest debts are now being paid off over much longer periods of time.

So what's better? Paying high interest for a few years or paying lower interest for a few decades? Well, you have to do the math, and then you have to figure out if you are just giving yourself more rope with which to hang yourself.

Before

$245,000 mortgage @ 5.25% amortized over 20 years, monthly payments of $1,650

$15,000 other debt @ 18.99% which would be paid off within 3.5 years with $500 monthly payments

Total Monthly Payments: $2,150

Total Principal Paid: $260,000

Total Interest Paid: $155,000

Total Principal and Interest: $415,000

After

$270,000 mortgage @ 4.75% amortized over 20 years, monthly payments of $1,740

Total Monthly Payments: $1,740

Total Principal Paid: $270,000*

Total Interest Paid: $145,000

Total Principal and Interest: $415,000

* Extra $10,000 covers fees and penalties to break current mortgage plus new CMHC premiums

Monthly cash flow saved: $410

So in this case, the math works, especially if the monthly cash flow savings of $410 is put to productive use, like contributing to an RRSP or building an emergency reserve. There are many variables at play here: interest rates, amortization, fees and penalties for your specific situation. You may find the overall cost of borrowing to be higher or lower than your current situation. Always run through the math.

But the more important consideration is whether or not you will get back into the habit of spending more than you earn. If that does happen, then what do you do the next time you've racked up too much debt? Refinance again? The vicious debt spiral can only be stopped once you master your monthly budget. If you can run a surplus for six months without problems, then by all means take a look at refinancing. But if you can't run that surplus, don't kid yourself: The same short-term thinking that caused you to run a deficit will cause you to tighten that noose around your neck.

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