Refinance or Downsize? Using Home Equity to Pay Down Debt

Homeowners often borrow beyond their mortgage, taking on additional personal debt for home renovations, household furnishings, and general living expenses.  As long as their income remains sufficient to service their debt, it’s not a problem. But what are their options when their debt gets out of control? For a homeowner who owes money on credit cards and unsecured lines of credit and also has equity in their house, the question becomes even more complicated.

Is it better to get a second mortgage and refinance or is selling the house and downsizing a better option?

The most significant problem with refinancing is that it doesn’t reduce total debt and, therefore, may not solve your client’s debt problem.  Refinancing $70,000 in credit card debt with a second mortgage may lower the interest paid, but the total debt remains unchanged.

Refinancing generally works best when it can be used to refinance all unsecured debt.  Borrowing for a second mortgage to repay $20,000 in credit cards when you have $50,000 in total credit card debt, is only a partial solution, leaving the home owner with higher mortgage payments as well as very high credit card payments.

Another problem with refinancing occurs when the second mortgage moves a homeowner into a high-ratio mortgage. An analysis of all homeowners who filed a bankruptcy or consumer proposal with my firm shows that 9 out of 10 of those homeowners carried a high-ratio mortgage at the time of their insolvency.  The average mortgage amounted to 92% of the net realizable value of their home, so they had minimal equity.

However, it’s not necessarily a refinanced, high-ratio mortgage that’s the most significant problem.  The average insolvent homeowner we deal with owes an additional $73,500 in unsecured debt, and it is that unsecured debt that becomes the trigger for personal bankruptcy. In other words, their high-ratio mortgage means they are also high-risk. If refinancing does not also solve the underlying budgetary problems, your clients are likely to continue to rack-up new credit card debt to replace the old.

Alternatively, if your client has sufficient equity to cover all of their unsecured debt, they can afford the resulting monthly payments, and they want to keep their home, refinancing is a reasonable option.  However, your clients should understand that refinancing converts unsecured debts into a debt secured by their home.  If they don’t pay their unsecured debts they may risk a wage garnishment, but if they can’t pay secured debts, like a second mortgage, they risk foreclosure.  That’s a significant risk.

If that risk is too significant, they can also consider two other options:

  1. Downsizing. By selling the house and using the proceeds to pay off their unsecured debt, their financial stress level will be significantly reduced.  If they have sufficient equity to pay off all of their credit cards and other secured debt, it may be possible to buy a smaller, more affordable house.  If not, renting may be the prudent option until they can repay the remainder of their debt, replenish their cash reserves, and save for another down payment.
  2. A consumer proposal. It is a viable solution to keep a house while also eliminating unsecured debts by making a formal arrangement with creditors through a bankruptcy trustee. For example, if your client has $70,000 in unsecured debt (a typical amount for an insolvent homeowner), but only has $20,000 of home equity, they can’t borrow enough against the house to pay off their unsecured debts. However, they could offer a consumer proposal of perhaps $30,000 (say $500 per month for 5 years) as a settlement to their creditors. The creditors accept the deal because $30,000 is more than the $20,000 they would get if the house was sold in a bankruptcy proceeding, and your client is happy because they keep their house and eliminate $70,000 in unsecured debt.

Not everyone qualifies for a consumer proposal so professional advice is required but, for many insolvent homeowners, it’s a great solution.  The proposal payment ($500 per month in this example) is often a lot less than the minimum payments on $70,000 in unsecured debt, so the debtor’s cash flow improves immediately, making it more likely they can maintain their mortgage payments.  It’s a win-win situation.

I have also seen instances where a debtor chose to do both: downsizing their home using the equity from the sale to make a proposal to their creditors. In this situation, they have the best of both worlds, their debts are eliminated and their budget is balanced.

The choice should be based on sound advice from appropriate professionals. As real estate professionals, you can advise your client as to the value of their home, any equity they may foresee, and provide housing alternatives to consider. A trustee can advise on the financial impact of a second mortgage versus a consumer proposal. Only after weighing all of this information can a client make an informed decision.

 

Doug Hoyes is a licensed Bankruptcy Trustee and Chartered Professional Accountant (CPA) and co-founder of Hoyes, Michalos & Associates. Doug has extensive experience helping Canadians manage their debt and has appeared as an expert in the media and with the Canadian senate on personal insolvency matters.


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