Wednesday, June 1, 2016
The Perils of Refinancing
How much can you save? Taking on more debt - which almost always happens in a refinance - doesn't necessarily save you anything, even if it frees up "cash flow". Cash flow isn't wealth.
I received a refinancing offer in the mail the other day. Since I don't have a mortgage, it was of no use to me. But it was fascinating as to how these deals work and how they get people (including me, in the past) into trouble.
As I noted in earlier postings, there are a number of ways to "time shift" money, and borrowing is one of the most obvious ones. You can borrow money now and end up in a world of woe later, even though things seem swell for the first few years. It is like selling one of your kidneys. All fun and games and a new car when you are in your 20's. But later on, you'll pay the price when your remaining kidney is shot.
Refinancing is appealing as it lowers monthly cash-flow rates. During the high-interest-rate era of the 1980's and 1990's many of us had mortgages as high as 14%. I had one at 11-5/8% at one time. An offer to refinance at "only" 8% seemed like a godsend at the time, even though it negatively affected my finances overall, due to my poor financial habits.
And one of those bad habits was taking "cash out" to pay off other debts. You see, when the refinance game started (when interest rates went down in the 1990's) the deal was to lower your rate, which is what I did when we refinanced for the first time. Our monthly payment was lower (whoo-hoo!) but of course, we basically pissed away what little we had paid down on the loan for the first five years - and added more to cover closing costs.
As the refinancing market got saturated and rates declined, they started offering "cash out" deals to allow people to pay off higher interest loans, such as car loans and credit card loans. Take a short-term loan, amortize it over 30 years, add to the balance on your mortgage, throw in a few grand in junk fees and points, and while your monthly payment is lower, your overall net worth is lower as well.
When that well was pumped dry, they started offering ARMs, which is where the trouble began. Once people got addicted to ARMs, they went with even lower and lower rates - often "come on" rates of a few percentage points (whose actual cost was made up in points). This lowered monthly payments for a few years, but eventually the piper has to be paid.
Let's take a look at this offer in the mail and see why it could be a harmful deal. Today, it is hard to get much lower than the fixed rates of 4.5% or so. Thus, the refinance people have to resort to games, such as floating ARMs, to get you to refinance. This offer is for a 2.75% 5/1 ARM which has an effective annual rate of 3.463%.
For a mortgage of $355,000.12 (the offered amount) the monthly payment sis $1449.26. If you are coming from a 4.75% mortgage with a payment of $1852 per month, this is a "savings" of over $400 per month, but only in cash-flow. There are no actual savings.
You see, you are resetting the clock on the mortgage to 30 years again, so you might end up paying more interest overall by refinancing. For example, if you compare the two 30-year mortgages, you would see that at 4.75% you are paying $311,665.30 in interest over 30 years. This is a lot more than the $166,732.23 at 2.75% over 30 years - in fact almost double. Of course, the 2.75% loan is only that rate for five years, so it is really a false comparison.
But assume you've had your house for 10 years and have been making payments at the 4.75% rate. Your remaining balance is only $285,847 or so, and over the remaining 20 years, you'll pay only $157,483.60 in interest. The same amount, refinanced over 30 years, will yield $134,253 in interest payments, a much, much smaller "savings" than 50%. But again, no one is offering 2.75% for 30 years, only for five years. And even then, not 2.75%.
You see, the mortgage requires two "discount points" which means you have to pay two percent of the balance of the mortgage at the onset. For our $355,000 mortgage, this comes to $7100 added to the balance of the loan (with interest paid on that as well!). And if you are looking to refinance, well, you ain't got $7100 laying around, so you do fold it into the balance of the loan. So right off the bat, you are $7100 poorer than when you started. And let's not forget "origination fees" and "document fees" and "overnight courier fees" (often charged even when nothing is overnighted) and other "junk fees" added into a loan. You may also need an appraisal, so throw in $300 to $1000 for that (the later what we paid in New York State!).
And this assumes you aren't taking "cash out" (adding even more to the balance of the loan) to pay off other debts, such as credit cards and cars or student loans or whatever. Taking a car loan of five years and amortizing it over 30 isn't saving you money, it is costing you more, as you will end up paying a lot more interest.
But the real kicker is that after five years, the loan "resets" at prevailing rates. Currently, these rates are around 3.5% to 4.0% with no points (which goes to show you, getting a loan in response to some mailing is a shoddy idea). What those rates will be like in five years is anyone's guess. Given that rates today are at historic lows, it makes no sense to go with an ARM. It is all but guaranteed that rates in five years will be far, far higher than today.
Let's assume Harry and Harriet Homeowner bite on this deal. They borrow the $355,000 offered in the mailing, have the required 740 credit score and Harriet is a vet (as required by the loan terms). They had a balance of $285,847 on their house, but had two car loans, student loans, and credit card debt totaling about $60,000. With the points on the loan and closing costs, the total comes up to $355,000 - the amount offered in the mailing. They go to closing and put no cash down and eliminate all of their monthly loan bills for one low monthly payment of $1449.26
The Homeowners are ecstatic. They have taken a monthly cash-flow requirement of well over $3000 for credit card debt, student loan debt, and car payments, and reduced it to under $1500. No more struggling to pay the monthly bills! No more nagging credit card debt that was increasing over time!
Now, if they were smart, they would take that $1500 a month they were putting into higher interest debt and applying to this lower-interest debt and bring down the balance in a real hurry.
But they aren't smart. They are human. How do you think they accumulated all this debt in the first place? Plus, the credit card company, seeing their balance drop to zero overnight, sends them a letter saying, "Congratulations Mr. & Mrs. Homeowner! In view of your excellent payment history, we've increased your credit line to $20,000!" - and that was just for one of their four major credit cards.
So rather than try to chip away at this debt, they go out and spend more. And quite frankly, the amount of "surplus" income in their cash flow isn't the $1500 a month they are "saving" in debt payments. Since they were living beyond their means for years, they were living on borrowed money - which is why their credit card debt kept increasing and why it was quickly becoming intractable credit card debt.
And that is why the Homeowners bit on this refinancing deal in the first place - they were starting to get desperate. The credit card bills weren't getting paid on time and the limits on the credit cards were being breached on a monthly basis. The refinancing offer was a lifeline.
Compounding this problem is the fact they refinanced on an ARM. After five years, the rate resets to "market rates" which could be 5% or more. They could be 7%. Who knows what they will be in five years or ten? And no, you can't "refinance" at that point to a lower rate, as the rates have gone up. And since they have added to the balance of their debt, if market values ever go down, they cannot refinance as the debt-to-equity ratio can't exceed 70%.
(Quite frankly, the limits imposed on these offers are so strict, few qualify for the best of terms, as I am assuming the Homeowners have here).
And in five years, well, their old cars have worn out and the Homeowners bought new ones - and ran up more credit card debt. Plus they needed that new furnace and the kids needed braces. And of course, they took that "dream vacation" after refinancing, as they could "afford it now".
The end result is, even more debt piled upon debt. And now they can't refinance again, as they are maxed out on debt load - in terms of their income and the equity in their house. They literally have no where to turn. And if they start making late payments on credit cards, or worse yet, their mortgage, their credit rating will be shot, making refinancing impossible.
Now all of this may sound harsh, but it is based on real-world experience - that of myself and my neighbors. I was never so dumb as to go for the ARM, but I did do a few refinances in my day, adding to the balances of loans, taking out cash, and generally being an idiot. And yes, I went right out and spent that "savings" in my monthly cash-flow rather than apply it toward reducing debt as I should have.
Others I know did even dumber things and were unlucky (or dumb) to get caught in the downturn of 2009. They refinanced again and again (one lawyer cheerfully telling me she was a "serial refinancer" - as if this was something to be proud of. She had a $5000 pocketbook). And when Real Estate values went South, they got upset and asked "who took all the money away?" when in fact no one did, they just spent phantom equity in their home on vacations and handbags and luxury cars, and now they owed all the money they spent.
Now to be sure, refinancing isn't always a nightmare. Most people don't stay in their homes for 30 years and pay off their mortgage over time. The average person moves every 5-10 years depending on region and demographics. This makes the 2% in "points" all the more lucrative for the banks. Serial refinancers end up adding these points to a loan over and over again.
But if your house continues to increase in value over time, and you make your payments (and maybe make a few extra to bring down the balance) you can sell out and walk away with no debt. But if you have loaded up your house with debt, there may be no equity to take out at the end of the day (particularly after paying 6% commission and closing fees) to use a down payment on another house.
Also if you have only 20 years left on your current loan (or 25 or whatever), refinancing for the same term might make sense, as it insures you really are paying less in interest. Not only that, the rates for 15 and 20 years mortgages are far less than for 30 year ones, and competitive with ARMs amortized over 30 years.
And it goes without saying that a fixed rate mortgage with no fees or points (if you can get one!) is going to be a better deal in the long run than paying 2% for the privilege of borrowing money.
If I had been smarter about refinancing, I would have refinanced for a shorter term (20 years) equal to the current length of the loan I had. And I would have shopped around aggressively on price and points to get the lowest rates and least amount of add-on fees. Instead of adding to the balance of the loan, I would have been decreasing it.
And rather than celebrating a refinance as an example of stellar financial acumen and spending yet more money, I should have taken it as a warning sign that I was living beyond my means.
But a lot of folks (including myself) did the opposite. Offered cheap and easy money, we took it and failed to think about how we were going to pay it back. Once you have loaded a house up with debt, your equity drops to nothing. And a lot of people end up "staying in their house" for this reason. How many folks have you heard say, "Well, there is no point in selling, as I wouldn't get much more for it than the loan balance, and then where would I go?"
I was fortunate (or smart) to sell out at the peak of the market, pay off these debts and walk away with cash. We can't always count on being fortunate or smart, particularly today. Refinancing sounds like a lot of fun, and the carrot of the lower monthly payment is awfully attractive. But it can be a trap for the unwary. If you are thinking of refinancing, make sure it is part of an overall financial plan, and not just time-shifting more debt so you can live beyond your means today.