Many of us are hoping to finally get out of debt for 2007, especially after a year that saw interest rates and monthly payments rise across the nation.
As real estate values sank, the average savings per family in the U.S. hit the lowest level since the Great Depression and household debt rose to historical levels. Record numbers of consumers holding interest-only mortgages, adjustable rate mortgages, as well as burdensome credit card debt were hit the hardest. But the news is not all doom and gloom, especially for those who act now and plan ahead to shrink their debt.
Many credit counselors advise taking advantage of attractively priced fixed-rate mortgage refinance programs and home equity loans to consolidate and pay off high-interest, high-risk loans. Fixed-rate loans can be leveraged into substantial savings if you use a low fixed-rate to pay off costly adjustable rates. For instance, if you are paying 18 percent on a pesky credit card but you borrow a home equity loan at eight percent to pay it off, you automatically pocket 10 percent. Use the money you save to pay off more debt and soon you’ll be out of the red completely.
Here are some tips and solutions for those who want to eliminate their high interest rate loans:
Credit card and other high interest consumer loans can be paid off using a home equity loan, to put the brakes on accelerating interest and fees. And while interest paid on consumer debt is not tax deductible, interest on most mortgage and home equity loans — and the points paid to do a refinance — usually is. That can translate into significant savings at tax time to offset the cost of loan processing fees.
Use a fixed-rate home equity loan to pay off your adjustable rate debts, interest-only mortgages, and other loans that are getting more unwieldy as rates rise. You can still lock in a competitive rate, and with a fixed rate you won’t have any unexpected changes in your payments for the remainder of the life of the loan. Plus, you’ll gradually pay off the principal, which increases your equity and solidifies your net worth.
Make two “half payments” per month, instead of one full payment. The way a bi-weekly payment strategy works is somewhat complicated to explain, but easy as pie to execute. The most important thing to understand is that because of how interest is calculated, the net effect of paying a portion every two weeks is that you’ll make the equivalent of 13 payments per year.
And you’ll do it without paying a penny extra. All you have to do is pay half of your monthly installment two weeks before the due date. For example, if your monthly mortgage payment is $1,200 — due on the first day of each month — you make a $600 payment by the 15th, followed by another $600 paid by the first of the month. Within 12 years you will have lopped approximately one year’s worth of payments off the back end of your mortgage. Over a loan payback period of 20 or 30 years you can easily save thousands of dollars in interest.
A “cash-out mortgage refinance” lets you borrow more than needed to pay off your first mortgage and then walk away from the closing table with money in your pocket. You can use the extra funds to pay off debt. But beware of cash-outs that leave you owing too much of the value of your home. Refinance programs that let you borrow more than 75 percent of the underlying value of your property can get you deeper into debt. A cash-out refinance works best for those who have untapped equity and can consolidate and vanquish other loan obligations without exceeding the 75 percent loan-to-value (LTV) ratio.
One additional piece of advice passed along by mortgage finance experts is to take the “two percent rule” with a grain of salt. This rule of mortgage economics states that there must be at least a two percent differential between the interest rate you now pay and the new interest rate you plan to refinance into, for you to break even in time for a mortgage refinance to make financial sense. In other words, if you have a 10 percent interest rate on a fixed-rate mortgage, refinancing to eight percent (two points lower) is not enough to make it worth the closing costs and loan application fees — at least according to the two percent rule.
But there are noteworthy exceptions. If, for example, you plan to stay in your home for a long time — rather than selling and paying off the mortgage within the next three to five years — then a refinance that saves you less than two percentage points of interest may still save you money. Always do the calculations to determine for sure how soon you’ll start to reap real benefits.
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