Last week we talked about different ways to look at your debt and how not all debt is equal. This week we wanted to talk about ways you can organize your debt to put yourself in a better financial situation without necessarily paying any of it off. One way to do this is using secured debt to consolidate any unsecured debt you may have.
Let’s look at Sam Spender again. As a reminder, he had a monthly income of $10,000. His monthly bills are a $2,000 mortgage payment, $700 car payment, $ 800 student loan, and he has a $1500 credit card balance. Sam’s debt to income ratio is total income divided by total debt which is $10,000/$5000= 50%.
We see that Sam has a mortgage payment, so he has a house. Houses are typically a person’s most valuable asset and are commonly used to collateralize debt.
If we look at that asset and its debt from above, we see much more than just the associated monthly payment. We may see that Sam has $100k left on his mortgage that he has been paying on and maybe the property has appreciated to $500,000.
Example time: his house with a mortgage balance of $100k that is appraised at $500k. This example means you have $400k of equity to work with, so let take the monthly bills above.
Credit card balance $1500
Car loan $20,000
Student loan $50,000
Refinance your house now with a total mortgage of $171,500 for say 30 years and now mortgage payment is $720-$800 range. Reapply this to the debt ratio $800/$10,000 =12.5%.
Sam just went from having $5000/mo in disposable income to $9,200 per month and his net worth is exactly the same.
A question that many would have if considering this strategy would be, why would I pay for a car over 30 years? Or, my house is almost paid off, why would I extend it? Both are very valid points to consider, so let’s address the car concern first. If you pay off the car and take the monthly car bill of $700 and apply it as an extra payment towards the mortgage a 30-year mortgage from 10/01/2021-10/01/2051 now becomes a mortgage from 10/01/2021-10/01/2033 and you still have a monthly income of $8,500. Now extending your house payments. Let’s say you were comfortable with spending $5000 a month in the first place, so take the extra $4,200 and apply it directly to the mortgage and now it is a payoff date of 10/27/2024.
So in this example if you were just going to roll everything into your house and make the minimum payment and spend the rest, it may not be the best plan. But, you can see how appropriately consolidating debt can put you in a more flexible situation to get new debt if you need it and can put you in better position to pay off your debt faster with the better terms you can get with secured debt.
This is by no means a blanket recommendation for rolling all your debt into your home. It is just an example of how careful use of debt can actually free up cash flow and assets to give you a more secure overall financial picture.