Smart Money Podcast: The Psychology of Debt, and When to Refinance

Liz Weston: Welcome to the NerdWallet Smart Money podcast, where we answer your personal finance questions and help you feel a little smarter about what you do with your money. I'm Liz Weston.

Sean Pyles: And I'm Sean Pyles. As always, be sure to send us your money questions, call or text us on the nerd hotline at 901-730-6373. That's 901-730-NERD, or email us at [email protected]. We are here to help you, so keep your questions coming. Also, if you want more Nerdy goodness delivered to your devices every Monday, hit that subscribe button.

Liz: And if you like what you hear, please leave us a review. On this episode of the podcast, we're talking with mortgage nerd, Holden Lewis, about when it's a good idea to refinance. First though, this week in your money segment, Sean and I are talking about the psychology of credit card debt.

Sean: One of our data journalists, Erin El Issa, recently released a report that dug into American's attitudes toward credit cards and credit card debt.

Liz: Yeah. And some of the background is this was a survey, online, commissioned by NerdWallet. It was conducted between July 30 and Aug. 3, and Harris Poll asked 2,033 U.S. adults where they are in their credit-building journey and how they feel about credit cards and credit card debt.

Sean: And some of the findings were really interesting. There's a pretty big split in how Americans view credit cards. A little over half said that they were helpful, while around a quarter of Americans said that they're dangerous, and close to one in 10 said that credit cards are evil.

Liz: Evil. I love that, evil.

Sean: Yeah. Possessed and evil, these inanimate objects.

Liz: Yes. They're coming to get you.

Sean: But I totally understand these conflicting points of view because credit cards can make life easier, but they can also kick off a spiral of debt for some consumers. They have really high interest rates often, and they can become overwhelming. So Liz, how do you view credit cards?

Liz: They're like a chainsaw, so they're a great tool in the right hands and they will cut off your hand if you use them the wrong way and make a bloody mess. OK, I think we're done with that particular metaphor.

Sean: They're evil.

Liz: I don't think that way at all. I am a huge rewards hound, I love all the free travel we've gotten from our credit cards, and we never carry a balance. We never pay a dime in credit card interest. So that's why I think they can be a really great tool, but you do have to learn how to use them. And I think most people aren't taught — most people get their first credit card, rack up a debt, look how much interest they pay, and they walk away horrified.

Sean: Right. I actually had a different machine analogy for credit cards.

Liz: Oh, tell me.

Sean: I was going to say that they're like a car, it can get you to where you want to go but if you don't keep tight control over it, things can get really disastrous pretty quickly. So, I have had credit card debt in the past, and I've carried a balance, but I'd never paid interest. I always took out zero-APR cards, mostly when I was moving somewhere because I knew I had to get new furniture, everything just adds up so quickly. I didn't want to deplete my savings, but I wanted to cover it and also, like you, get those points. So, that's why I'm a big fan of zero-APR cash-back cards. I use them for almost all of my spending, but then at the end of the month I pay them all off.

Liz: Yeah. And they have a lot of benefits like purchase protection; there's a middle person in there. If you have a problem with a vendor or merchant, you have somebody on your side most of the time to help you sort things out. And also the fraud protections are really great, you basically are not responsible for fraud. And that can be really helpful in these times when there's a lot of identity theft. I don't want somebody having my debit card number and a direct line into my bank account. That just makes me nervous.

Sean: One thing that was also interesting in this report from Erin was that close to half of Americans said that their feelings toward credit cards were influenced by the experiences of loved ones. And I definitely fall into that camp. I'm pretty wary of credit card debt, even though I have used it in the past, because I've seen how bogged down it has made some people in my life because they haven't been able to control it. And part because they were pretty tight on cash, they weren't making enough to keep up with their expenses. And then they fall into that spiral that we mentioned earlier, where you can't pay it off one month and you keep racking up interest, you keep racking up other day-to-day charges, and it can become very overwhelming.

Liz: Yeah. Because most credit cards have really high interest rates and that's what keeps people in debt. If you're paying 15, 16, 20, 22, 24% interest, it's really hard to get out of that hole.

Sean: But similarly, by the same token of me being influenced by people around me, since I've joined NerdWallet four and a half years ago or so, I think I'm just seeing them as very useful tools that you can deploy strategically. And so now I feel like I'm one-upping the credit card companies whenever I use them, because I've gotten so much back in cash-back points. And they can be very advantageous if, again, you keep tight control over how you're directing them.

Liz: Yeah. I was in the habit of paying off the bill in full. That was something that my mother taught me from the very first time I got a credit card is always pay the balance in full. And obviously life happens and that's not always possible to do. But having that habit and having it so ingrained that you just do not carry a balance I think really helped me use it as the tool it should be, which is for convenience and to build credit. And that was something else about Erin's study I thought was really interesting is, there's a big chunk of people who basically say, "Well, I don't need credit right now so I'm not going to worry about it." And that's a little dangerous, don't you think?

Sean: Yeah. It's a little dangerous maybe a little short-sighted as well, because maybe you don't need credit today, but it's worth having those good habits of maintaining and building your credit. So that when you do need it — when you apply for a new line of credit whether it be an auto loan or a mortgage, whatever it is — you've shown that you have a steady record of on-time payments because that is crucial. It's one of the most important things that people will look for when they're going to approve you or not for credit. So even if you are paying it off, even if you don't really want to use it, we're all stuck in the system, so you might as well use it as best as you can. And like me, like you, Liz, get some money from it as well basically for free just for using these little pieces of plastic.

Liz: Yeah. And I think a lot of people don't realize also that credit's used in a lot more than just lending decisions and getting a credit card. It's used by insurers to set auto premiums and homeowners premiums. In most states, landlords use credit information to decide who gets apartments, and employers use credit information too, but not credit scores. So that would be less relevant for this particular discussion, but still credit is all through our financial system. So it's something you need to pay attention to.

Sean: Mm-hmm.

Liz: So another thing I thought was really interesting about the study had to do with bad debt and bankruptcy. So, most Americans — almost three quarters of us — think that having credit card debt is inherently bad. But many of them also say that there's no amount of credit card debt that would make them file for bankruptcy. And I thought that was really interesting. I think that shows there's still a huge stigma around bankruptcy, and people think that they just would dig their way out. No matter what, they wouldn't file. But the reality is if you are deep in debt, bankruptcy can be another good tool. Not that anybody would rush into bankruptcy, but it can really help you, right?

Sean: Yeah. It's interesting the fact that people view credit card debt as inherently bad, I think that it relates to how people view themselves as personally responsible for all of their decisions. And the fact is that people aren't making these financial choices in a vacuum, you can't bootstrap your way out of really dire economic conditions because the system is very difficult for a lot of people. So, I think it's a little disheartening to see that a lot of consumers are still trying to blame themselves for when they get into credit card debt. And they think that it's a personal failure, when in fact it's part of a broader system that makes managing money very difficult. And bankruptcy is merely a tool that can help you when you're in the worst situation possible to get a fresh start.

Liz: Yeah. I used to think of bankrupts as basically deadbeats. You know, that they brought it all on themselves and this is where you wind up. And then I did a pretty broad study talking to hundreds of people who've filed for bankruptcy. And I was shocked at how often it's a life event. It's somebody, the breadwinner, died, or they had a baby that was in the NICU, the ICU for newborns, and they wound up with hundreds of thousands of dollars in medical bills. And this is what lands people in bankruptcy. It's not running out and buying too many shoes, it's life events. So that gave me a lot more compassion.

Sean: Well, I remember talking with you about exactly this, and I think you said something along the lines of how people are three disasters away from filing for bankruptcy. Almost everyone. You can lose your job, you can get that big medical bill, you can end up having a car accident, something that totally upends your financial life. And what we need to realize is that it could happen to anyone, so I think if we all bring a little more --

Liz: Well, like the pandemic.

Sean: Yeah. Like a pandemic which then gives you medical bills that you're responsible for. So I think if we all bring a little bit more compassion to that, I think hopefully people can bring a little bit more compassion to themselves and how they view their own credit card debt.

Liz: Yeah. And I think we've just seen in real life happening in real-time, what happens when life happens? We had a pandemic, people lost their jobs and they lost their health insurance and they got sick, there's your three disasters right there.

Sean: Mm-hmm. As we've seen, credit cards and the way we view them and our relationship to money is very complicated, very subjective and based on your own history and personal experiences. So anyone out there listening that wants to share your experience and how you think about credit cards, write us at [email protected]. I would love to hear from you. Let's get to this episode's money question which comes from Amy in Pennsylvania. She writes, "I'm seeing a lot of offers for refinancing a mortgage at a low rate. We bought our house last year with a 30-year mortgage and have a 4.5% interest rate. How do we know if we should refinance?"

Liz: Ooh, that's a great question because interest rates are so low right now.

Sean: They are. But because she just got that mortgage last year, I'm wondering how that might factor into this too. To talk with us about Amy's situation and whether it might be a good time for her to refinance, on this episode of the podcast we're talking with mortgage Nerd, Holden Lewis.

Liz: Hey Holden, welcome back to the show.

Holden Lewis: Dudes! Oh, I love to help people get a really good deal on a mortgage, so on site.

Sean:Well, that's why we brought you on because our listener Amy has a question that seems kind of simple, but I'm wondering if it's one of those cases where it could be a little more complicated than it seems. Basically they just got a mortgage last year, their interest rate is 4.5%, and they're wondering if it's still a good time to refinance or not. So, what are your initial thoughts on this?

Holden: Can we first start out by defining what refinancing means?

Sean:Sure. Go ahead.

Holden: Yeah. I think sometimes people have this fuzzy idea that refinancing is a good thing, but they don't know exactly what it is. So when you refinance your mortgage, you're getting a new mortgage to replace the old one, kind of like trading in a car. The new mortgage pays off the old one then you have a new home loan and one that preferably saves you money in the long run.

Sean: Mm-hmm.

Liz: But there's a lot of different reasons to refinance, right? It's not just getting a lower interest rate.

Holden: There's tons of reasons to refinance. You can refinance to get a lower interest rate, you can do it to shorten the loan term, which might mean that you have higher monthly payments, but you pay less interest over time. You might refinance to get rid of FHA mortgage insurance, to get cash out and to pay for renovations, there's just lots of reasons to refinance.

Sean: So, thinking of Amy's question, which is how should we know if we should refinance? It seems like the "should" is dependent upon what their specific goal is and if they can get a refinance that would help them meet that, right?

Holden: That's right. And with this one, it's kind of a slam dunk. With a mortgage rate of four and a half percent, if Amy has good credit, she can refinance for around 3%, maybe a little bit more, maybe a little bit less. So that's a huge savings in interest rate, there would be immediate monthly savings in a mortgage payment.

Sean: I'm wondering how long it might take them to recoup any fees.

Holden: You know when you get a mortgage, you have to pay a whole lot of fees. So what that means is is that when you refinance to save money on your monthly payment, you want to keep the home long enough for those accumulated savings to exceed the fees you pay. In other words, if you're saving a hundred dollars a month by refinancing, and you paid $3,000 in fees, your payoff time is 30 months — 3,000 divided by 100. We want to own that home for at least 30 months after refinancing.

Liz: I've thought you should have a shorter period where you recoup it just because the future is unknown. You really don't know how long you're going to be in the house that maybe you, most of the time, that maybe you should shoot for 18 months, does that make sense, Holden? Or should it really be a longer period or a shorter period?

Holden: It really should be a longer period because for a lot of people they're chopping maybe three-quarters of a percentage point off their interest rate. And at that rate might take them five, six, even seven years to break even, and, you know, that's just fine if you're really confident that you're going to have that home for another five, six or seven years. And I think a lot of people actually are confident in that, that they are in their forever home, and so they'll refinance gladly and have that payback period of, say, six years.

Liz: OK. That makes sense.

Sean: There's a new fee associated with this, right? Do you think that that would balance out? Or how do you think that comes into play?

Holden: Fannie Mae and Freddie Mac have instituted a fee of half a percentage point of the loan amount for people who are refinancing. So what that means is, let's say you're refinancing for $300,000, your fee would be half of 1% of that, or $1,500. Now, a lot of lenders, they're not going to ask you to pay that upfront. What they're going to do is they're going to increase the interest rate, maybe an eighth of a percentage point, maybe a little bit less than that. So the bottom line is that this fee is going to increase the payback period for a lot of people by about a year. I don't think that this new fee really changes a lot of the math for people when they're deciding whether to refinance.

Sean: It seems like right now is a really good time to shop around for a refi deal. But I'm wondering how you can spot what a "good deal" is for a refi. How do you define that, Holden?

Holden: I define it by shopping around and then looking at the deals that you're quoted. The biggest mistake people make when they get a mortgage is not comparison-shopping. You can save more money by comparison shopping for a mortgage than for a car. So why wouldn't you? And what that means is that you apply with your current lender and then at least two other lenders. Applying for a mortgage, it doesn't commit you to anything, but when you file a formal application, I mean you're actually applying for a loan. The lender has to give you a three-page document called the Loan Estimate.

Holden: For a really good explanation of it, the Consumer Financial Protection Bureau has a page that annotates it and just tells you exactly what you're looking at and what it means. And the page three of the Loan Estimate has a summary of how much that loan is going to cost you in the first five years, we're talking fees, principal and interest. And then you can just look at that little box on page three, and you can compare the loan side by side. And most of the time it's going to be pretty obvious which is the best deal. And if that deal is saving you money, then go for it.

Liz: And Holden does it cost anything to apply to that point?

Holden: It does not.

Liz: OK.

Sean: Except you will have a hard pull of your credit, right? So that's a certain price to pay, but if you're going to be shopping around for a refi deal anyway, you should just be expecting that to happen.

Holden: That's correct. Because when you apply for a mortgage, all the mortgages you apply for in a 45-day period all count as one credit inquiry.

Liz: Holden, the fact that they paid fees to get their current mortgage, should that keep them from applying again? I mean, that might also come into play if you refinance a mortgage and then a few months or a year later decide oh, I'm going to actually save more money if I do it again. So have the fees that you already paid, should that be part of your calculations at all?

Holden: No. The fees that you already paid on your current loan should not count into your calculations of whether to get a refinance. It's kind of a psychological thing that we have, it's called SAM costs, and you've already paid those fees and it just doesn't matter after you've paid those fees what you do afterward. I mean, if you can save money now by refinancing, it really doesn't matter what fees you pay to get the original mortgage. They were paid and that bell can't be unrung.

Liz: You can't get that money back one way or the other.

Holden: That's right. You can't get that money back. And since you can't, you might as well walk forward and save money.

Liz: Now, Holden, we've talked about this before, but I'm a big fan of getting your mortgage paid off before retirement. But I'm a little leery of 15-year loans, especially with the economy the way it is now, it's really hard to predict who's going to lose a job, what's going to happen going forward. So, I favor the 30-year loan with maybe the lower payment and you can always make principal payments so you can increase your payment if you want to get it paid off faster. But you like 15-year loans, right?

Holden: Well, I do like 15-year loans because the interest rate is lower. But personally, when it's me, I really prefer to get a 30-year loan and amortize it myself over a shorter period, which means basically paying extra every month when I can afford to do so. And hey, I could probably afford to do that for the next 15 years and pay it off in 15 years, but it is nice to have a 30-year mortgage. And at times of economic distress, to be able to pull back and make that minimum payment on a 30-year loan if it's a lot more comfortable to do.

Liz: So you have that flexibility?

Holden: That's right, having a 30-year loan, it does give you more flexibility than with a 15-year loan or a 20-year loan. And the reason is the payment is lower on the 30-year loan, the minimum required payment is lower on a 30-year loan. So if you can't afford a higher payment, when you're say between jobs, but you can still afford that 30-year payment, then you're golden, you're fine.

Sean: Holden, I'm wondering if it's any more difficult to get a refi right now with so many people rushing in to get one.

Holden: It is more difficult to get a refinance now for a couple of reasons. First, a lot of people are getting refis right now. And so there are long wait times, you might have to wait six or eight weeks after applying before you can even close on the loan. And in the meantime, they're going to want to keep checking to see if you're employed. I mean, they might actually call your employer multiple times in the last week before closing, just to make sure you still have your job. And there's another issue, which is credit. Lenders not only are looking to lend money to people with good, steady jobs, but they also are looking for people with high credit scores. And so what you're seeing is the average credit score on loans has been going up for about two years. And now for a refinance, the average credit score is higher than 740. So lenders are picking people with high credit scores to actually give loans to.

Liz: They're basically reducing their risks. They don't want to take any chances right now.

Holden: Lenders do not want to take chances at a time of high unemployment. Especially at this time when there's not only high unemployment, but people, really, they can just lose their jobs or have their hours cut back at little notice through no fault of their own, with this big external thing that's hitting us.

Liz: Yeah.

Sean: It seems like interest rates are going to continue to be low though. According to what we've seen from the Fed, it seems like for the next year or so, it will remain around where they are now. Are there any other trends you think people should be aware of as they think about refinancing?

Holden: There's a lot of people who are doing cash-out refinances. What that means is — let's say you owe $100,000 on your mortgage and your house is worth $300,000, so you have $200,000 in equity. When you refinance, you could borrow more than that hundred thousand you owe, you can borrow, say, $150,000 and you get that $50,000 extra as cash. And you can use that to do renovations on your house. That's the main thing I recommend using cash-out refinance for. And so, a lot of people are doing cash-out refinances, but the Fed has sent the signal that it's going to keep short-term interest rates low for a long time. And that means that the interest rates on home equity lines of credit are going to remain low for a long time, because those go up and down, according to the Fed's rate policy. And so, the bottom line is, I think if you want to do some renovations, it might be a better idea to refinance for the loan amount that you have and then get a home equity line of credit, or HELOC, to pay for renovations.

Liz: Well, and that, I'm always a fan of the HELOC as an emergency fund as well. Sort of a backup emergency fund or whatever cash you have. But if you use it all for home renovations, you won't have it available for emergencies.

Sean: That's true.

Holden: There's one fly in the ointment of that, and I'll tell you my personal experience. So, we had home equity line of credit with a small balance, like $5,000, during the housing crash. So in 2009 our HELOC lender sent us a letter saying, "We have decreased your credit limit to the amount that you owe now."

Liz: Aw!

Holden: So basically, it was like they were just telling us, "Pay it off and don't charge anything to it." And it made my wife so mad that she personally went into the bank and closed the account.

Liz: Oh dear, yes. Yeah, nothing beats having actual cash in the bank in terms of savings, but that HELOC can be, for some people, it can be a nice backup. Hey Holden, I wanted to ask you about, because there's so many different moving parts to shopping around for a refinance, are there calculators? Are there ways to figure out what the deals are going to cost you? Or when it's a good time?

Holden: Oh, yes. NerdWallet has an excellent refinance calculator where you plug in your loan parameters that you have now, how much you owe, and where your interest rate is and that kind of thing. And then you can plug in the parameters of the loan that you're looking at, how much you want to borrow, what the interest rate is. And it will tell you what that break-even point is as long as you estimate what the closing costs are going to be. So that's a really good thing. And then I also want to plug our current mortgage rates page, it tells you the average rates for the 30-year fixed, 15-year fixed and 5/1 ARM. Those rate averages are updated daily.

Liz: Great. And ARM means adjustable mortgage, right?

Holden: An ARM is an adjustable rate mortgage. Yes.

Sean: It seems like everyone is hopping on this refi train right now. And I'm wondering when it might be a good idea for some people to maybe wait at the station, catch the next train in a couple of months or a year. Because it seems like everyone's just rushing in and maybe they're not thinking about some trade-offs they might have to make.

Holden: There are a few people who should wait. First folks with a credit score say below 720. I think it's a good idea to work on that credit, get your bills paid on time and increase your credit score to at least 740 really would be ideal, and maybe even higher. And then there's a lot of folks who had an interruption in their income this year. They were laid off, they're furloughed, whatever, or their hours were cut. Those folks, they might just want to wait a little while and have a longer period of employment.

Sean: All right, Holden. Thank you so much for talking with us.

Holden: Thank you. And Amy, good luck.

Sean: Now, let's get into our takeaway tips. First up, gather information and get an estimate on your break-even period for your refi.

Liz: Next, shop around. Apply to at least three lenders so you can compare rates and terms.

Sean: And lastly, there is no need to rush. There's a big bottleneck of people applying for refis right now, so if your credit isn't where it should be — 740 or above — then spend some time improving your scores here in a better position to refi in the future. And that is all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us your questions at 901-730-6373. That's 901-730-NERD. You can also email us at [email protected] and visit nerdwallet.com/podcast for more info on this episode. And of course, remember to subscribe, rate and review us wherever you're getting this podcast.

Liz: And here's our brief disclaimer, thoughtfully crafted by NerdWallet's legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This Nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.