Saturday, June 1, 2019

The Pros and Cons of Refinancing

Most people refinance their home at least once in their life. Is this a good or bad thing? It all depends on the facts and circumstances.

I came of age in an era of very high inflation and high interest rates and high unemployment. Unemployment was running at least 10% in the late 70s and early 80s as was inflation. Mortgage rates were as high as 14% in that era. Some folks today like to claim that they have it worse than previous generations, in an era of ultra low unemployment, low inflation, and absurdly low interest rates - as well as a surging stock market.

If only we had a working time machine to send people back to 1979.   You know, the good old days when cars barely made a hundred horsepower and sounded like a bucket of bolts when you stepped on the throttle and gasoline was only available on even and odd days depending on your license plate number. But I digress.

Prior to that time, refinancing your mortgage was almost an unheard-of thing. You got a 30 year mortgage on your house and you made the payments on it until you paid it off, at which point you were very close to retirement age. Then you went off into retirement land with your house paid for, or you sold the house and moved to Florida using the proceeds to buy your next home.

But as interest rates started to drop in the 1980s, refinancing became more popular.  Banks were in search of lending business, and people with 13 or 14% mortgages were eager to find lower rates and lower monthly payments.

But during the real estate boom in the late 1980s and again in the 2000s, we saw people refinancing for different reasons. Interest rates hadn't really changed that much, but people were realizing their houses had appreciated substantially in value - at least on paper - and wanted to cash out on some of this phantom equity to pay off other debts or to buy things like luxury cars or do home improvement projects.

Thus, the cash-out refi was born, along with the home equity line of credit or HELOC.

Should you refinance your house? That is a piece of advice I would hesitate to give anyone because it is very fact-specific and dependent upon your circumstances.  In general, though, I would advise to borrow as little money as possible, as you have to pay back borrowed money.

What are the advantages of refinancing? They are kind of obvious:

1.  Your monthly payment may be lower.  If you are merely refinancing at a lower rate, and not taking cash out (or taking much cash) your monthly payment may be lower and you'll pay much less interest over the life of the loan - presuming you are locking into a lower fixed-rate loan and not a variable-rate note.  With a lower monthly payment, your finances may be a little easier and you can put more money away into savings.   Sadly, most people don't actually do this, but rather take cash-out so their monthly payment is the same, if not higher.

2.  You can take cash out.   I am not sure this is an "advantage" any more than going to the payday loan store and having that fan of $20 bills (like they show on the billboards) is an advantage.  All loans have to be paid back, with interest.  So yes, you end up with a pile of money, but often easy money gets spent easily, and then you are stuck paying it back.   Your net worth is now lower than it was before.

3.  You can consolidate debt.   If you have gotten into credit card debt problems (yes, I did it, more than once) you can get a "breather" and refinance your debts with a cash-out refi.  The problem is, of course, is that you are taking short-term debts for things like a meal you pooped out last week, and are financing them over 30 years.   It is possible that this can be a way to recover one's finances, but the problem is, most people (myself included) after doing a re-fi, consider themselves financial geniuses and go out and rack up more credit card debt.  Dumb!

4.  You can avoid Mortgage Insurance:   In some re-fis, if the appraised value of the property has gone up enough, the ratio of debt-to-equity has dropped to the point where mortgage insurance (which is usually required for first-time buyers) is no longer needed.  This can drop your monthly payment by a hundred bucks or so.   Of course, it is often possible to contact your existing lender and ask them to discontinue mortgage insurance, if you can show them (with the appraisal or tax assessment) that the value of the home has increased to the point where you no longer need the insurance.

5.  Taking non-deductible debt and making it deductible:   One argument made by mortgage brokers (who have no dog in this fight, right?) is that if you do a cash-out refi, and pay off old debts, the new debt is tax-deductible - well, the interest is, anyway.   There are some problems with this argument.  To begin with, technically you can only deduct interest for a purchase money mortgage.   Thus, if you buy a house for $200,000 and finance it for $200,000, you can deduct interest on the whole two hundred grand.  But if you re-fi for $250,000, you can only deduct for the interest on the first two hundred.

Calculating this is, of course, a nightmare, and since most homeowners want to take the deduction, they simply deduct all the interest.  And the IRS, having very limited resources, doesn't audit these sorts of things very often - or have any way of knowing you are deducting interest on a loan that exceeds the purchase amount.   But the law is clear on this - you cannot simply deduct interest an any loan secured by your home, only the PMM (Purchase Money Mortgage) or amount equal to the purchase price.

And of course, with Trump's new tax law, things are even more complicated.   For many people in the lower brackets, itemizing deductions makes no sense anymore.  And for people in the very high brackets, there is a cap on how much interest and property taxes can be deducted.   For interest, older loans are grandfathered in, so refinancing may limit your deduction abilities.  But we're talking about a loan value cap of $750,000, so if you are in that bracket, good for you.

You can't deduct your way to wealth, as I have noted before.   If you qualify for a tax deduction or tax credit, take it.  But using the IRS as an investment guide is never a good idea.   Maybe you get a tax credit for buying an electric car.  But that doesn't mean buying one makes sense for you, or that buying 100 of them will generate a profit for you.   Similarly, taking on more debt for tax deductions makes no sense.  It may make such debt seem more palatable, but less debt is even a better deal.

6.  It's better than a second mortgage or a HELOC:  This falls into one of those arguments that sticking a knitting needle in your eye is better than stabbing it into your heart.  If you are trying to take "cash out" of your home (i.e., borrowing more money and using your home as collateral) it is probably more efficient and you'll get a lower rate with a cash-our refi than you would with a second note or a HELOC - Home Equity Line of Credit.   Since second notes are second-in-line to get paid back in the event of foreclosure, the interest rates are usually higher.   That being said, less debt is better than more debt - always.

7.  You can shorten your loan term:   Some folks use a re-fi as an opportunity to switch to a shorter-term loan.   a 20- or 15-year loan will likely have a lower interest rate than a 30-year-fixed.   If the interest rates have dropped in recent years, you could re-fi and have not only a lower monthly payment, but also a shorter loan term!   You could end up owning your home, free and clear, in five or ten years less than before.  Sadly, few people do this, but rather go for a new 30-year loan.

So what are the disadvantages of refinancing?  Well, I've hinted at them above, and put these hints in the body of that, lest someone clip out only the first part and use it to cheerlead for refinancing.  The pitfalls are many, and in 2009, we saw firsthand how refinancing can be very, very dangerous.  Here are some of the pitfalls:

1.  Your home value may decline:  As we saw in 1989 and again, 20 years later in 2009, home values can peak and bubbles can burst.  It is possible to refinance your house based on an inflated appraisal value in the middle of a bubble, and then, five or ten years later, discover your home is worth less than the balance on the loan.   As a result, you can't sell the house for what you owe on it, and if you lose your job (say, in a recession) you end up in foreclosure.

We saw a lot of rending of garments and tearing of hair in 2009 as people whined about how unfair it was they were "losing their home" due to foreclosure.   But if you read the rest of the story, many of these folks claiming life was "unfair" had actually taken cash-out of their houses to buy luxury cars, go on vacations, pay off credit card debt, or invest in other properties.  I myself did the latter (well, maybe all three), but was fortunate enough to be sitting down when the music stopped.  I saw the market go berserk and sold out in time.

Others were less fortunate in their timing.   If you are going to cash-out in a re-fi, don't get too greedy and take too much cash out - and mortgage brokers will encourage this, even if you don't "need" the money.

Some folks take cash-out to remodel their home.  This is fine and all, but bear in mind that even the best remodeling jobs return pennies on the dollar - fifty cents at best.  So if you take out thirty grand to do a kitchen makeover, at best it might increase the value of your home by fifteen grand.   No matter how you slice it, you come out behind and further in debt.

2.  You are resetting the debt clock:  As I noted above, most people when refinancing, go with a new 30-year note.  Many have intentions of going to 15 or 20 years, but the mortgage broker will helpfully suggest that a 30-year note "is just like a 15-year note, if you make an extra payment once a year!"   But of course, being human beings, we spend that extra payment money on beer, instead.

By resetting the debt clock there are a number of effects - you end up paying more interest over time, and you end up with the possibility of perpetual debt.

3.  You are paying more interest:  The first few years of any mortgage are basically all interest payments.  You pay $1000 to the mortgage company and are chagrined to see $950 of it is interest and only $50 is principal.  If you refinance every five years, let's say, for 30 years, you'll end up paying almost every penny in interest.  Meanwhile, your stupid neighbor, who isn't as clever as you are to become a "serial refinancer" just ends up owning his dumb old house, free and clear.  What a dummy he is!

4.  Perpetual Debt:  As a result, you end up in perpetual debt.   Many people rationalize this, just as they rationalize a drug habit.  "I'll always have a mortgage!" one co-worker told me.  "I'll have to work until I'm 70!" another says.  "I'm a serial refinancer" one giggled to me.  In a way, it is like how many young people rationalize student loan debt - as if living large in college was inevitable, and student loans were a "mortgage on your career."

This makes me very sad, because people do have choices.  And the folks making these rationalizations often have designer clothes and the latest $1000 iPhone.   They are signing up for more and more debt, in order to have trinkets.  Sort of like how we stole Manhattan from the Indians for $24 worth of shiny baubles.

Problem is, debt eventually has to be paid off, and a lot of people are not thinking about this.  They enter their retirement years hopelessly in debt, and have no way of paying it off, short of bankruptcy (which does not discharge student loan debt).  Some way to retire!

5.  Fees, Fees, Fees:  That friendly mortgage broker isn't your friend, he is a merchant, and he makes money by originating loans.  Of course he is friendly to you!  He's making money on your loan.  Be late with one payment and see how friendly they are then...

Fees can be tacked on everywhere - loan origination fees, mortgage points, mortgage insurance, document prep fees, fee fees, whatever.   It pays to scrutinize these and talk them down - often lenders will pad on fees and only reduce them if you threaten to take your business elsewhere.  It pays also, to shop around.  Again, never fall into the trap of thinking that borrowing money is a privilege!  You are paying these people, not vice-versa.  They money they "give" you is your own, and you have to pay them back for it.

As with buying a house, the fees can negate savings.  In the Real Estate sales business, it is said that unless you plan on staying in the home for five years, it isn't worth buying, as the transaction costs will eat up any capital gains, in a normal market.  Yet, we knew people in Washington, DC, who would move every three years or so, to get a "better house" as they got a raise in pay - they were treading water and slowly drowning.

The rule of thumb for refinance is that if the money you save pays back the transaction costs within a year or so, it is probably worthwhile to refinance.   Of course, as outlined above, most people these days aren't refinancing to save money, they are doing it to spend money they don't have and as as result, their monthly payment is more, not less (or at best, break even).   So the balance of the loan increases not only by the cash-out, but by the fees - often in the thousands of dollars - added to the loan balance by the lender.

Blinded by monthly payment, most people go along with this.  But if someone said to them, "Hey, mind if I take $5000 out of your checking account?" they would balk.

6.  Your Net Worth:  As I intimated above, most people look at these transactions in terms of monthly payments.  I make $X a month and spend $Y a month, and so long as X>Y, I am doing OK - right?   Well, not always.  You see there is your overall net worth to consider - and most people have no idea what their net worth is (and this is sad, as today there are calculators, such as the one Merrill Edge provides, which can show your net worth on a daily basis).

So, for example, say you have $50,000 in your 401(k), and have $20,000 in car payments and another $10,000 in student loan debt.  Your house is worth $250,000 and has a $150,000 mortgage on it.   Your "net worth" - if we include the value of the house (some financial experts don't) is the sum of your assets ($250,000 + $50,000 = $300,000) minus the sum of your debts ($150,000 + $20,000 + $10,000 = $180,000).   Hence your net worth is $120,000.

Now, let's say you refinance your house and take out $50,000 in cash-out.  Your mortgage is now $200,000.   You pay off your car loan and student loans so the mortgage becomes your only debt.  You use the remaining $20,000 for home improvement projects, which increase the value of your home by $10,000.

Your net worth is now ($260,000 + $50,000) - $200,000 = $110,000.    As you can see, even using this money to pay off other debts results in a net drop to your net worth of $10,000.  Of course, I am not factoring in the fees and loan costs, which might ding your net worth by another two to five grand, depending on the lender or broker.  And I might also note that that car loan, which had only two more years to go on it, is now amortized over 30 years.   So in the long haul, you are adding a pile of interest to your life, as well as decreasing your net worth.

It pays to look at things in terms of overall transaction costs instead of monthly payment mentality.  When you are debt-free and living off savings, as I am, you are forced to do so.  When you have no savings, lots of debt, and a steady paycheck from a "job" the monthly payment mentality is awfully attractive.

My story:  We financed houses and investment properties and refinanced them over time - sometimes again and again.  We survived the meltdown of 1989 and 2009 because of good timing and luck.  In 1989, we had bought a house (not a condo, as many of our friends did) and held on during the next few years, as home prices leveled off and in fact, dropped slightly.  Our friends with condos lost their shirts.  Our house was on a 3-2-1 buydown with an eventual interest rate of 11-5/8% (!!!) and eventually, we were able to refinance it and eliminate the mortgage insurance as well.  This resulted in a lower monthly payment.

It would have been fine if we had left it at that - resetting the 30-year mortgage clock after five years or so, but we refinanced again, to pay off personal debts (car loans, credit cards, swimming pool) and before long, our $189,000 house was mortgaged for over $300,000.   Pretty dumb, eh?   Fortunately, property values continued to climb in the DC market and we were never upside-down on the home.  And since it was on two deeded lots, a developer was willing to pay us nearly $700,000 for the property just prior to the meltdown, in 2005.

Never confuse getting lucky with being brilliant.  We took that cash and went out and bought another house in New York - and took out another mortgage to fix it up.   That was pretty dumb, in retrospect.  I think we even refinanced that mortgage once, as well - or was it the one here on Jekyll?  I forget.

With the investment properties, we had variable-rate loans.  I would avoid variable-rate loans like the plague, particularly today in this era of low-interest.  Rates have only one way to go - up.  And when they go up, odds are, you can't "refinance to lock in a lower rate" as the mortgage broker (remember him?  The one with no dog?) likes to say.  He lies, a lot.  To himself, too.

But for commercial properties, "callable notes" with variable rates are usually the only option.  I refinanced these at lower rates, using a bank I was a founding shareholder of.   I took cash-out, not to pay off credit card debt or buy a car, but to buy another property.   And we did this again and again and ended up with several properties, all of which generated a positive cash flow, paid the mortgage payments, paid the insurance and taxes, and were increasing in value.

During that time, interest rates dropped.  I was going to refinance my office building and I called the VP of the bank where I had the loan (the bank I had founder's shares in).   He said, "no need to re-fi, we'll just adjust the interest rate on the note!"   You see how it works, once you have money, it is a lot easier to make more of it.   The poor slob facing foreclosure doesn't get such consideration.   Life is unfair.

Then the real estate market went berserk.  When people offered us two or three times what we paid for properties, we sold.  And again, don't confuse being lucky with being brilliant.  OK, so we made one smart decision, but then made a dumb one - we put the money into a vacation home - a personal residence that didn't generate income as the investment properties did.    We did OK with it, enjoyed it for a decade and then sold it off and paid off the rest of our debts.

What would I have done differently?  I would have bought the vacation home, but bought a much cheaper one (one we did look at, which was more of a cottage than a house, but also could have been easily rented in the winter to students at the local women's college).   I would have borrowed less and spent less - we took "cash out" of our properties, which is to say, we borrowed money from Uncle Tomorrow to have fun today, using the excuse that we were working so hard, we deserved a treat now and then - using someone else's money, the us of tomorrow.

Home improvement projects were fun and all, but it all tasted the same to the bulldozer when they tore down our house.   I learned a valuable lesson there - it pays to maintain a home, but adding things to it - particularly things that can detract from value - is just throwing money away.  If you enjoy that sort of thing, fine.  Just realize how much it is costing.

But, as they say, you can't unbark the dog.  And someone reading this will say, "Well, that's all very well and fine, but my situation is different!"  And it very well may be, which is why I don't give advice.  Advice is easy to give, hard to take, and people often take advice, twist it around and then apply it poorly and then blame the advice-giver when it goes horribly wrong.

I guess to boil it down to a nutshell, it would be this - borrow the least amount of money you can.  Even a thousand here, or a thousand there adds up to "real" money (if you saw a thousand dollars on the street, you'd stoop down to pick it up for sure!).   Realize the money your are borrowing is your own money, and has to be paid back.   Don't fall for the monthly payment mentality to the point where you are blinding yourself to the overall costs and transaction costs.   And don't turn refinancing into a lifestyle choice - as many people do, refinancing again and again, in life.

Because all loans get paid off eventually.   And someday, you'd like to be debt-free - or wish you were.