While explaining Morty, I left with a parting shot: Be careful about consolidating your debt. And before I continue, i will make the disclaimer that I’m not a financial advisor, just a curious number cruncher. So not entirely satisfied about not giving an example, I’ve now had the time to consider the model more carefully to present you with some numbers. So here goes…
Scenario: 2 loans exist, one for a house taken out in May 2004 for 800K at 14%, and one for a car in May 2006 for 160K at 16%. Come May 2009, you decide to consolidate your debt (for whatever reason). Â Note,Â I will purposefully line up the dates and use nice round numbers to get the point across. Also, the interest rates used reasonably reflect the situation in South Africa at the time (as my memory serves). Â But regardless of the actual numbers, the same maths (and hence lessons) apply. The math follows:
- 800K at 14% over 20 years = 9.9K repayment
- You will end up paying 2.4M for the house over 20 years
- That’s 1.6M in interest alone
- After 5 years, you have paid off 600K, but have only 54K in equity
- 160K at 16% over 5 years = 3.8K repayment
- You will end up paying 230K for the car over 5 years
- That’s 73K in interest alone
- After 3 years, you have paid off 140K, but only have 83K in equity
Now you want to consolidate your outstanding debt under one loan. And, we’ll assume you’re refinancing under more favourable interest rates- else why would you even reconsider it? So what you actually owe at this stage will be the sum of the settlement values on each loan, which will largely depend on the agreements you have in place. Let’s assume everyone plays nice and they let you off with the original loan less your current equity. It could be a lot worse! You now owe a total of approx 840K which you need to refinance, and because one of them is a house, you might end up reasonably re-mortgaging over 20 years again:
- 840K at 11% over 20 years = 9.2K repayment
- You will end up paying 2.2M for the combined loan over 20 years
- That’s 1.4M in interest alone
So, where do you stand at this point?
You’ve definitely made a short-term saving in terms of your monthly repayments (10+4 vs 9). Your cash flow is a lot smoother! But with 2 seperate loans though, you would have paid a grand total of 2.6M (2.4M + 230k) over the lifetime of those loans. With a consolidated loan, you would have paid a grand total of 2.9M (2.2M for new loan plus payments already made on previous loans of 740K). Plus, your cash flow potentially deteriorates over the medium term. Once the car loan would have matured, you’re paying almost the same repayment (especially if by this time the interest rates have dropped) anyway. And then in the long term, you’ve got an extra 5 years of repayments to cover which is worth 0.5M of cash flow in the future.
All, in all, the simple summary of it that is you end up losing approximately 300K in the long run.
But it’s not all that bad- it can actually be to your advantage too. If the difference between the original financing rates and the new financing rates are large enough, you can actually save yourself a lot of money in the short, medium and long term too. But that requires approximately a 5% difference _at least_.
So think twice before you jump fall for the debt consolidation marketingÂ trap. Make sure whoever is advising and structuring it for you that they go through all the numbers and look at it long-term. Obviously the refinancing will always benefit the lender which is expected and acknowledged, but just how much is fair and reasonable? We all have the right to make informed choices- and we should insist on that right- and just because it might sound technical or complicated or involve a lot of numbers, doesn’t mean it can’t be explained in a way that makes sense to you.
Hope that helps to at least think a little more deeply about the choices out there….
3 replies on “Refinancing Model”
and to be fair, if you’re in a jam, that extra 300K over the long term really represents what you’re prepared to pay to not lose the ground (or assets) you’ve covered thus far. so if 300k smoothed out over the next 20 years is a fair price to keep the house and car, then it’s really not such a bad ‘loss’.
the alternative, in a jam, would be losing either one (or both) and then having to rent for a while and then to try again. _that_ option, could easily be worth a lot more than 300k.
Bondbusters has just released an article on the topic:
The Debt Consolidation alternatives – what’s best for you?
Hopefully by combining the numbers above here, what they have to say might make some sense now, in particular:
…but because you have carried your short term debt into the long term you will inevitably end up paying back a larger amount of money over the longer course of the repayment term.
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