What Should You Do With Extra Cash From Refinancing?

I was sitting in my local coffee shop recently and a gentleman sat down next to me with his friend. He was apparently a mortgage broker giving some business tips to a younger broker in order to help him increase his business.

Something I overheard him say caught my attention: “You can tell your borrowers that they can use cash from the proceeds of their refinanced mortgage to pay off their car loan. And, it is tax-deductible!” Then I heard the younger broker say “That is a great idea; I will start telling all of my customers about that.”

I did everything I could to not jump out of my seat and tell him no! After I cleaned up the coffee I spilled from the shock of hearing such a statement, I started to think that there are possibly thousands of borrowers following this errant type of advice.

So, let me provide some guidelines as to what things generally should and should not be funded by using proceeds from your refinanced mortgage.

Refinancer Beware

One thing you should avoid at all costs is using mortgage proceeds to pay off an auto loan. It is generally a terrible idea to pay off a 3- to 5-year loan with a 30-year mortgage, or even a 15-year mortgage.

Think about it: Assuming you opt for a 30-year mortgage, you will still be paying on your car when it is either lying in in a heap in the junkyard in 25 years or when it is part of the tuna can you opened for dinner last night. And you will be paying a great deal more in interest.

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Assume you want to pay off a $10,000 car note with three years remaining at 9% annual percentage rate by using the proceeds from refinancing your mortgage at 4% over 30 years. If you had kept the car note, the total interest you would pay over the final three years would be $1,448. This cost is on top of the $10,000 principal you will have paid off.

However, if you roll that $10,000 debt into your new mortgage, the total interest you will pay over the life of the loan will be $7,187, or nearly five times more than the higher interest car loan! A better idea would be to refinance your car note to a new 3-year loan at 4%. The total interest payments you will make over the lifetime of your new car loan will only be $629, or about half that of your current loan. (A good credit score could help you refinance at a lower rate. You can see where you stand by viewing your free credit report summary on Credit.com.)

As for the broker’s claim that the loan will be tax-deductible, any additional tax deduction may help you in mid-April, but the massive amount of interest you will pay over the life of the mortgage will be much higher than any benefit you may reap from the potential tax deduction.

A Possible Exception

Besides car loans, you should generally not use mortgage proceeds to finance school loans (which may be deductible separately), boats, motorcycles or vacations.

If, however, you are only able to make the minimum monthly payments on your credit cards, it might make sense to use refinance proceeds to pay them off. Paying only the minimum amount due on a high percentage credit card will most likely take 20 to 30 years to pay off the card. For example, if you have a $10,000 credit card balance with an APR of 15% requiring a minimum payment of 1% plus monthly interest due, you will be paying on that card for around 30 years before you have paid it off. (You can crunch the math using this credit card payoff calculator.)

Transferring that debt to your tax-deductible mortgage may be a better idea as long as you don’t charge your card up again. It also is reasonable to use mortgage proceeds to pay off improvements to your home that actually add value to the home like an additional bedroom.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.