All Debt is Not Created Equal

Roger Schlesinger
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Posted: Mar 06, 2008 10:23 AM
All Debt is Not Created Equal

Does it matter that the headline is correct or do you believe I am just splitting hairs? If you owe a bundle how important is the fact that the parameters of the debt can be widely different? Is unsecured debt really unsecured? Why is mortgage debt generally superior to all debt? If you fail to understand the differences in debt, the nuances of the questions and

the need to be able to move to correct the mistakes, you will spend a great deal of your life being the odd-man out.

Let us start with credit card debt, which most people will tell you is unsecured (not attached to any of your assets). In reality this debt is more secured than specific debt such as your home mortgage and your automobile. Why? Because the credit card companies have spent a "ton" of money to make sure you cannot discharge their debt through bankruptcy as easily as you used to be able to. Unsecured debt is really secured by all of your assets while specific secured debt is just secured, for the most part, by the asset used for security. Failure to make your car payment and your car will be reposed. If their is a deficiency after the repossession it generally is written off.

Mortgage debt is secured but definitely different than normal secured debt. In most states if you take out a mortgage to purchase a house it is considered a "purchase money" mortgage. That term used to be reserved for a mortgage given by the seller of the property

to the buyer. Again in most states it simply means the mortgage you take to buy the house regardless of who is giving it to you. These mortgages, purchase money, are deficiency free, again in most states. In other words you can walk away from the property without any worry about any loss to the mortgage holder. THIS IS NOT TRUE FOR REFINANCED MORTGAGES! (however it can be - read on).

In states where a mortgage is really a note secured by a deed of trust the holder of the note can foreclose on the borrower if payments are missed by electing to sell the house at a public auction to the highest bidder, after sufficient notice is given. If that occurs and the buyer loses the house all liability is dismissed in case of a loss.(Coincidentally, the current owner can go to the foreclosure sale and buy the house from the lender who is foreclosing on him. When that happens, rarely, it is really a form of public negotiation.)

In the aforementioned states when a lender wants to go after the borrower then they use a judicial foreclosure, through a court, and the liability is assigned to the borrower. This is rarely used because the borrower has a year to right the ship and pay the debt and get the property back. Lenders do not want to hold the property for a year and thus this method is more a "big threat" more than an actual solution.

Writers note: These are general rules and can differ in your state, county or township.

Check with the real estate official to be sure of the rules and regulations in your area.

Debt is priced in relation to the security given the credit granter. Mortgages are considered the safest debt because they are secured by , for the most part, the most stable asset.

(current times would contradict that statement but over the long haul it is probably true).

Mortgage debt is currently priced in a range from the shorter amortization (time to pay back the loan) to the longer amortization. Rates run from the high 4% range to the 6% range for 10 and 15 year fully amortized loans. For longer amortized loans, 20 to 30 or even 40 years, rates go from the high 5% range into the high 7% range. Second mortgages and Helocs are priced higher. Most mortgages have interest that is tax deductible. This is not determined by the loan but by the economic situation particular to the borrower. (Check with your tax consultant)

Mortgage payments are lower than most every other type of debt because they can be paid over a longer period. However, if you check the relationship between the payment of other types of debt and the balance owed you will find that mortgages also are a smaller percentage of the payment/debt ratio than other debt regardless of the length of the payment. A ten year loan generally has a payment of near 1% of the original amount throughout the entire loan.

Credit cards now have a 1% of the balance owed each month plus interest and charges.

Credit card payments can be anywhere from 1.5% to 3.5% of the balance owed each month. Thus a credit card balance of $20,000 can have a $300 to $700 payment each month. A $75,000 15 year mortgage loan can have a monthly payment of $600.

There wouldn't be a relationship between the two if borrowers paid their credit card debt off in a timely manner, but that generally doesn't happen.

The point of this discussion is to get those who don't understand the major differences between debt instruments to see the advantages of home financing over short term financing from credit cards and other vehicles. The credit card example I show above will take 8 to 12 years to payoff if the minimum payment is selected each month. Therefore, it is time to consider using a better vehicle, your home mortgage, to payoff your household debt.

Most family's debt is generally 75%-90% home mortgage and 10% to 25% extraneous debt.

If you were able to wrap the entire debt into your home mortgage, a 15 year fixed, your results would be rather amazing. In the first 5 years you would pay off 20% of the loan, which should take care of the extraneous debt and leave you with your mortgage balance to be eliminated in 10 years. Your payment would most likely be the same or maybe even less than it was when each debt was paid separately but after 5 years you would have just a decade to go on the big debt: the home mortgage.

That result, ten years left on the home mortgage, is the payoff. By eliminating a decade or more of payments through proper management of debt you change your financial life forever.

Everyones results will be different because everyone enters the picture with a different set of conditions. If equity allows and earnings are sufficient when you are setting this up, the taking out additional cash from the house for reserves can help guarantee the results I have discussed. Run some examples for yourself and see what the picture will look like to you. It might be the best exercise you have ever done.