Refinancing during Chapter 13: Do not shoot yourself in the foot!

A couple of days ago I wrote a post about refinancing your home loan during an active Chapter 13. In that post I addressed the issue of how such refinancing impacts your budget and plan payment. You need to think long-term in refinancing, because your will not be able to hold onto the savings from the lower mortgage payments. This is aggravating, but benign.

There is a much more sinister trap that refinancing can land you in. You need to be careful when looking at refinancing within an active Chapter 13 as to how to any existing arrears on the original loan are treated. If you are paying substantial arrears through the plan, but refinance, then those pre-petition arrears are most likely to be paid off with the new loan. Essentially, a lender with arrears is not going to release their lien to allow a new lien to take priority over theirs until all sums due are paid. This includes those arrears.

If that happens, then your plan payment is still going to be just as high or higher depending on your new loan payment. But, where a certain amount of those payments were going to pay off the arrears at zero (0%) percent interest, now you will be paying interest on the same arrears in the new loan. Not only that, but the percentage of your plan going to unsecured creditors will likely increase significantly. This may all be fine with you if your heart’s desire is to pay as much of your debts as possible. However, it needs to be a conscious decision rather than one your stumble into.

So, if you are paying $10,000 in arrears at 0% interest in the plan on the original loan and then refinance, the $10,000 arrears gets “paid” from the proceeds of the new loan. Your principal is now $10,000 higher than on the original loan, but your plan payment stays the same or higher. You essentially just cost yourself $10,000 plus interest. Your may not feel it, though, because the actual month to month cost remains relatively stagnant.

When looking at refinancing, it is best to look at all factors to make a wise decision: new interest rate and savings from that, length of time left on mortgage, amount of arrears in the plan, and how much additional interest you will pay if the arrears are then out of the plan and in the new note.