Car refinancing traps

My previous entry mentioned how refinancing has become very common lately. A growing and alarming trend is car refinancing.

Just like with their homes, consumers roll unsecured debt into their car. Banks have become very creative and some of them allow amortization periods of eight years!

As a rule of thumbs, all debt except mortgage should be paid within 5 years maximum. Beyond that, you will pay too much interest and likely suffer from debt fatigue. Debt fatigue is when you feel overwhelmed and are likely to incur more debt.

The main issue with car refinancing is that people pay more for a depreciating asset. Unlike a home, a vehicle starts losing value as soon as it leaves the dealership. The brunt of depreciation occurs within the first 5 years.

When refinancing, people end-up owing –and paying- more than the car is worth!

The same happens when trading-in vehicles. Let’s say you have a 4-year old car with $ 10 000 left to pay on it. You walk into a dealership and trade-in that car for a new one at $ 25 000.

The dealer takes your old car back for $ 5 000 and extends you a loan for $ 30 000. Do you see the problem? Not only you owe more than your new car is worth, but you are also still paying for a vehicle you don’t have anymore.

Obviously, it doesn’t make sense whatsoever. Yet people are only looking at the interest rate and the low monthly payment. They fail to look at the actual cost and value of the car.

Bottom line, car refinancing is a terrible idea. The Federal Government has recently expressed concerns over this trend, but to date has no intention of intervening.

Mortgage refinancing traps

With interest rates still at an all-time low, refinancing has become a common trend.

A refinance is obtaining a new loan with better terms than the previous one. Refinancing is primarily to save on interests, and this is how people should approach it.

A consolidation loan is a good example of refinancing. By combining all your existing debts into a single loan, payment and interest rate, you save on interests and potentially pay-off your debt sooner.

Unfortunately, this concept has been widely distorted by banks and other financial salespeople. We are now “encouraged” to refinance to create more debt, and actually pay more interests in the process.

Besides a consolidation loan, the 2 other common refinances are mortgages and car loans.

Mortgages

Since 2008, the Canadian government has tightened the belt on mortgages. There are more conditions to obtain or refinance one. Refinancing is not the same as renewing.

Usually, when people refinance, they “break” their current mortgage, triggering a penalty. Renewing is negotiating a new mortgage when the current one is over, no penalty involved.

Before thinking about a refinance, you have to qualify for it. Under the new rules, you need to have at least 20% of equity in your home.

Then, do the math. If you break your current mortgage, you will be assessed a penalty; either 3 months of interest or the Interest Rate Differential penalty –IRD-.

The IRD is usually for fixed-rate mortgages. It is a somewhat complicated formula, but it could cost you thousands of dollars more than paying 3 months of interest.

Also factor in the legal costs. Registering your new mortgage is not free.

If after all the calculations, you will still save money with a new mortgage…happy break-up!

The biggest trap is refinancing to roll-in unsecured debt or to borrow more, instead of wanting to save on interests.

This can also be done on renewal too, unfortunately. The marketing machine is on full speed and well-oiled. The biggest selling point is that, by doing so, you will free-up cash in your budget.

This is actually true, as you are consolidating. However, banks and other like-minded people neglect to mention a couple of important points:

  • You are turning unsecured debts into secured ones, i.e. putting your home on the line. If you don’t pay your credit card balance, it is very unlikely the credit card company will go after your home. Your lender will, if you default on your mortgage.
  • You will pay more interest by amortizing your consumer debt over a 10, 15 or 20-year period. Most people have difficulties grasping this, as they only look at the interest rate.

You definitely need to calculate before jumping into a mortgage refinance. Most importantly, keep in mind interest rates will go up at some point.

If you decide to roll-in additional debt into your mortgage, you have to be disciplined and close the accounts. Refinancing is not a free pass to incur more debt.

I will talk about car loan refinancing in another post.