Debt consolidation during a period of rising interest rates

Debt consolidation is the conversion of high-rate debt into lower-rate debt in order to reduce total interest costs. Homeowners with large amounts of credit card debt who have equity - unused borrowing power - on their home have a consolidation option.

Whether or not it is in the homeowner's long-run interest to exercise the option, however, turns out to be a challenging question, the answer to which depends on the specifics of the individual case.

That makes it a calculator problem, where the challenge becomes finding the right calculator. This article will help with that.

Homeowners who have both a first and a second mortgage have the most consolidation options:

They can consolidate their existing nonmortgage debt into their first mortgage by doing a cash-out refinance on the first mortgage, leaving the second mortgage as it is. Note: A cash-out refinance is a loan for an amount that exceeds the balance owed on the previous mortgage that is paid off.

They can consolidate their existing nonmortgage debt into the second mortgage by doing a cash-out refinance on the second mortgage, leaving the first mortgage as it is.

They can consolidate their existing nonmortgage debt and the second mortgage into the first mortgage by doing a cash-out refinance on the first mortgage.

Calculator 1C on my website provides information about these options that is needed to make an informed decision.

The calculator provides two types of information about each option. One is the total monthly payment, which consists of the mortgage payment, mortgage insurance premium payment if any, and nonmortgage debt payments if any. Borrowers on tight budgets must be concerned that the monthly payment is affordable, but it should not be the major determinant of their choice.

The second type of information the calculator provides about all the options is their total cost over a period specified by the user. If the user's time horizon is, say, five years, the total cost of each option is the sum of the monthly payments over five years including lost interest, less the tax savings and reduction in total debt over that period. A borrower looking to have the largest amount of wealth possible at retirement should seek to minimize this cost.

Homeowners who have one mortgage and a large amount of high-cost, short-term debt that they want to pay off have only two options. They can refinance their mortgage with enough cash-out to pay off the short-term debt, or they can take a new second mortgage. You can take the shortcut using my calculator 3D.

The most important factor determining whether a debt consolidation is cheaper using a second mortgage or a cash-out refinance is the current level of interest rates relative to those at the time the first mortgage was taken out. If current levels are lower, a cash-out refinancing is likely to be better because the new first mortgage can have a lower rate than the existing one.

Because rates have been trending up recently after many years of low rates, a second mortgage is likely to prove cheaper in many cases. However, many other factors enter the equation.

These factors are pulled together by my calculator 3D, which computes all costs of both options over a future time period specified by the user. It also shows a break-even interest rate on the second mortgage - the highest rate you can pay on the second and come out ahead of the refinance option.

The second mortgage is the less-costly option if it is available at an interest rate below the break-even rate.

A critical question is what borrowers do after they consolidate? Borrowers who reduce their monthly payments should use the monthly savings to accelerate the pay-down of their mortgage balance, but many don't. Some view a payment-reduction consolidation as a license to take on more nonmortgage debt. A few years later, they look to consolidate again.

If their house has appreciated enough, they may be able to, but sooner or later they run out of equity. Some then write me asking how they can get out of the trap they have dug for themselves.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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