Friday, October 17, 2014

The Problem With Serial Refinancing

Why was serial refinancing a bad idea?  Why were people told it was a good one?

In the last decade, we have experienced a boom and bust in the Real Estate market, and many people have lost their homes or found themselves in "mortgage stress."   What caused this mess?  Part of the problem was the use of "serial refinancing" to allow people to live a lifestyle they really couldn't afford in the first place.   The idea of owning your own home went out the window in favor of perpetual mortgage payments.
Let's crank some numbers and see what I am talking about.   Jim and Cindy buy a house for $220,000 and put down $20,000 as a down payment and obtain a 30-year mortgage for $200,000 at 6% APR which at the time was a reasonable rate.  They pay about $3,000 in closing costs and have a monthly mortgage payment of $1,199.10 (P&I).

From the Bankrate Calculator, we know that after five years, they have paid $58,985.32 in interest payments and owe $182,510.78 on the house.

Wow, five years and you've paid over 1/4 of the value of the home in interest payments.  Scary, eh?   But that is how compound interest works - when you are borrowing.

After five years, they've run into some credit card debt issues from remodeling their home.   And since interest rates have dropped, (and home values have gone up) why not "refinance" their home?   The monthly payment would be less, of course, than the total of their old mortgage and credit card debt payments.   And in five years the home has increased in value.

So they refinance $220,000 on a new 30-year morgage at 5% APR which lowers their monthly payment to 1,181.01 and gives them some more breathing room.

The problem is, of course, they still owe the same amount of money, it is just now spread over a longer period and at a lower interest rate.   They have robbed the equity in their house to pay off credit card debt.  They also spent another $3000 in closing costs to the banks.

Freed of the credit card debt (and enjoying all those frequent-flyer miles) they decide to buy a new car.  And letters come from the credit card companies congratulating them on their financial acumen and announcing that their credit limit has been raised yet again.

Five years later, they are in the same pickle.   Lots of debt from lots of spending, and with car payments and credit card payments, it is hard to make the monthly payment on the mortgage.   And since their last refinancing, the house has gone up in value and interest rates have again dropped.

Since their last refinancing, they have paid another $53,725.43 in interest and now owe $201,683.97 on the house.  If you are astute, you already see they are falling behind here.

They get yet another new 30-year mortgage at 4% interest for $250,000, which gives them a monthly payment of $1,193.54.  Closing costs are again $3000.  Five more years go by and they pay another $48,484.81 in interest and now owe $225,678.97 on their house.

And of course, they get into the same pickle again - new cars, credit cards, expensive trips, meals at restaurants - all charged to high-interest rate "miles" or "cash-back" credit cards (of which they have six).  So they think, "no big deal, we'll just refinance again!"

But something has happened to the Real Estate market this time around.  The economy is tanking and home prices are falling.   Lenders are hesitant to loan money on houses, as many are "upside down" or "underwater".   They get an appraisal on their home (the bank requires one, this time around!) and discover that is worth less than the $225,678.97 balance on the loan.

They are insolvent.   Technically, they are bankrupt.   But they decide to bite the bullet, cash in savings from their 401(k) and make payments on all this debt for another five years before they run out of money and end up in bankruptcy court.   Pretty sad.

But what is interesting to me is how the banks make a lot of money out of all of this.   By resetting the 30-year refinancing clock three times, over 15 years they've paid $161,195.56 in interest payments and still owe $225,678.97 on the loan.

If they had kept the original loan, they would have paid $158,646.37 in interest payments and owe $141,609.08 on the house.

Now, some folks might argue, "Well, see, they only paid a little extra in interest as opposed to keeping the original loan!"   But that fails to take into account the remaining interest.   You see, if they kept the original loan, they would own the home free and clear, in 15 years, after paying another $73,030.01 in interest payments.  Their total interest paid would be $231,676.38

But now they owe another 25 years of payments totaling $131,118.96 bringing their total interest to $292,384.52 - a difference of $60,708.14.

Now this scenario is based on each refinance increasing the balance owed - that is a typical scenario that we saw in the 1990's and early 2000's.   And I know this from experience - I've done it myself.   I was lucky in that I sold out before the market went bust and was able to pay off all this debt.   Most other folks weren't so lucky.

The banks love refinancing, as they get lots of fees in the transactions.   Junk fees, points, and other fees can run into the thousands of dollars.   And appraiser's fees, tax deed stamps, recording fees, courier fees, and closing attorney's fees can run the real costs up $3000 to $5000 for the homeowner.   So in addition to this $60,000 in additional interest, add in $6,000 to $10,000 in closing costs for the two refinancings.

Of course, this is not to say that all refinancing is bad.   Suppose Jim and Cindy decided to refinance after 10 years - and did not run up a lot of additional debt?   And suppose Jim and Cindy decide to refinance the new mortgage for 20 years (as opposed to resetting the clock to 30 years again).  After 10 years, they owe $167,009.21 on their home and have paid $112,100.43 in interest charges, on the original loan.

Their new loan, at 4%, over 20 years, will have a monthly payment of $1,012.04 and over the 20 years left in the loan, they will pay $75,881.10 in interest for a total of $187,981.53 - over $100,00 less than in the first scenario and a savings of $43,694.85 over the original loan.   Yes, refinancing can save you money, provided you don't use it as a vehicle to cash out on your home's equity to pay off credit card debt.

The cause of the Real Estate crash of 2009 was the Jim and Cindy's of the world.    They lived beyond their means and borrowed from the future by taking short-term debts and amortizing them over long periods of time (30 years) using their homes as collateral.   They were "cashing out" on phantom equity in their home, which was "created" when housing prices took a ridiculous turn.

In the post 9/11 era, we were all encouraged to consume as much as possible, apparently to show Al Qaeda that we were not cowed.  I am not sure that was a good idea.

There were a few frugal people who used refinancing responsibly - to obtain a lower interest rate and thus lower their interest expenses.   But those folks were few and far between.   Most were like Jim and Cindy, who bought a Lexus and then financed it using their house.   We all did it.

Of course, if you talk to Jim and Cindy, they have another story.   The Community Reinvestment Act was to blame - by allowing "poor people" (code word for N-word) to buy houses "they couldn't afford" and that caused the collapse of the market.   Nice try, but no sale.   The collapse of the market did not occur in low-income homes, but in middle-class and upper-middle class homes.

So why did Jim and Cindy do this?   Well, the banks certainly encouraged it.   They made money off the interest they charged Jim and Cindy on their credit cards - as well as the 2-4% they charged the merchants for each credit card transaction.   They made money on the interest Jim and Cindy paid on each mortgage.  And they made money on the refinancing fees and points charged on each mortgage.   In other words, they made a lot of money - perhaps twice as much - compared to our second scenario where Jim and Cindy refinance once - and don't "cash out" equity to pay off debt.

From Jim and Cindy's viewpoint - aided by normative cues on the television (talk shows touting refinancing, advertisements, etc.) it "makes sense".  They lower their monthly payments (which is all that matters, right?) and they get a tax deduction for that mortgage interest, right? (actually no, not for debt beyond the original purchase price).  And they are "cashing out" on the boom in the real estate market, right? (actually no, they are just borrowing on phantom equity).

The mortgage broker tells them it is a swell idea.  The credit card company tells them it is a swell idea.   The bank tells them it is a swell idea.   In fact, few people at the time said otherwise.   So it was not hard to get caught up in the maelstrom.

Today, perhaps we see things differently.   Borrowing money is not cashing out on equity.  And by cashing out on phantom equity, you are robbing Peter to pay Paul - in particular, you are impoverishing the future you so the present you can spend more and live more lavishly.

And much, if not most, of this spending was for unnecessary things.   Luxury cars (when a good used regular car would do), restaurant meals (when you could eat more cheaply and more healthy at home), and tchotchkes that clutter up your home (which you end up selling in a garage sale for pennies on the dollar).

No, debt is not a good idea.  And no, we are not preordained to be debtors from birth.  The idea that "everyone has debt, right?" as set forth in a Bank of America cartoon, is just plain wrong.   It is possible to own yourself and not be a debt slave all of your life

It does require two things, though:
1.  You have to sacrifice and learn to live on less (less than you make); and 

2.  It requires you unplug from the media that provides the poor normative cues that encourage you to go into debt.
It really is that simple!  Not easy, of course.   But simple.