Refinancing? Weigh risks of debt consolidation

By Cathleen McCarthy

updated 2:38 p.m. ET Aug. 26, 2009

With mortgage rates still near historic lows, consolidating credit card debt in a refinance can substantially lower monthly expenses. Yet many financial experts advise against it.

Take the example of JoAnn and Ray Katz. Three years after Ray left an executive position, he found himself earning a fraction of his former income, while his self-employed wife, JoAnn, struggled to make up the difference in a faltering economy. With their savings dwindling and credit card debt mounting, they looked to their most valuable assets: their center-city Philadelphia home and a second house they were renting out. "We were property-rich and income-poor," says JoAnn.

The couple had refinanced six years before, but when mortgage rates dropped to historic lows in May, they saw an opportunity to eliminate their credit card debt by refinancing their home and rolling $25,000 of credit card debt into the loan. Thanks to an excellent credit rating and an appraisal valuing the house at $345,000 — four times what they owed on it — Ray and JoAnn managed to lock in a 30-year fixed mortgage interest rate of 4.8 percent, two points lower than before. They're now saving $1,000 per month — $350 less in mortgage, $650 less in credit card payments.

"I would only suggest this as a last-gasp strategy," says Susan Reynolds, author of "One-Income Household." "In general, rolling credit card debt into mortgage loans is not a good idea. You will pay significantly more in interest over the life of the homeowner's loan than you would if you chipped away at your credit card debt over a period of three to five years. Remember, home equity loans are secured. Credit cards are not. If you renege, they can pester you for payment and ding your credit report, but they cannot confiscate your home."

Todd Huettner, president of Huettner Capital, a mortgage brokerage specializing in debt consolidation, advises homeowners to answer three questions before rolling debt into a home loan:

• Why do you have this debt? "If you're spending more than you can afford, consolidating your debt will not improve your spending habits and will likely be harmful in the long run," says Huettner.
• What are the costs of consolidating the debt? Those additional costs can add up to thousands of dollars compared to a regular refinance. If it doesn't make sense to refinance without the debt, you're probably spending more than you're saving. "If rates are low enough, the costs of a refinance should be paid back by interest savings within the first five years, preferably the first two," says Huettner. "If not, you're paying a lot in closing costs and that will offset any interest savings. I have even seen people try to cash out equity from their house even though it meant the new loan would have a higher interest rate."
• Is there a more effective way to eliminate your debt than rolling it into your home loan? For example, a regular refinance may produce enough cash to cover the debt. "By timing the closing and your current loan payments, calculating any escrow refund and using incidental cash back, you can include several thousand dollars in your loan that wind up in your pocket," says Huettner. "For people who don't have much debt or where the costs of the cash-out are too high, this is often a better alternative." If your credit is good, there are still some 0 percent balance transfer credit cards that could help you pay the balance faster.

After working with nearly 5,000 families, Susan White of PlanPlus Inc. has her own reasons for advising against rolling debt into home loans. "The theory of turning higher debt rates (credit cards) into lower ones (mortgage) is a great idea," says White in an e-mail, "but it usually doesn't work because many of the people who end up in this situation have a habit of spending without conscious decision making."

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