I was meeting with a client the other morning who needed to either refinance or sell her townhome to access some equity to pay off her sister. If she decides to sell, she will buy another townhome closer to work, where as it will be pretty much business as usual if she refinances. A situation like this is a legitimate reason to refinance, but it got me thinking about all the clients I’ve met with over my 23 year mortgage career (as of this writing) and some of the reasons they wanted to access their equity.
Let me start with a reminder. I say reminder because in other posts and videos I have said that equity in a home is dead; it provides no return on investment. For example, let’s say Jim and Bob own identical homes right next to each other and the area of town where they live has been appreciating at 5%. Jim wanted a smaller mortgage payment so he put $150,000 down on his $300,000 home purchase while Bob wanted to invest a chunk of his money in an investment property and the stock market so he only put 20% down ($60,000) on his $300,000 home purchase and invested the remaining $90,000. Both homes appreciated 5% their first year so both were worth $15,000 more than when they purchased them in spite of the fact that Jim put 50% down and Bob only put 20% down. Bob’s ROI (return on investment) for his home is 25% (not including closing costs) because he had a $15,000 gain on his $60,000 investment. Conversely, Jim’s ROI is only 10% ($15,000/$150,000). Additionally, since Bob invested his other money in a house and the stock market, he has more assets that are creating wealth for him. Check out this link to see how much different their financial situations will be after 30 years: time-value of money.
Reasons not to refinance: #5 – A friend is refinancing his / her mortgage
If you have several friends who are refinancing their home, you may want to take a look at your situation to see if there is a valid reason for doing it. Maybe your friends know something that you don’t (rates dropped dramatically recently) and looking into refinance would be smart, but you should only refinance if it makes good financial sense for your specific situation. If you have ONE friend who is refinancing, it might be that he has a higher interest rate than you or he may be deep in debt and need to restructure his cash-flow situation so that he can make their mortgage payment comfortably every month. There may also be some other situation in his life that you don’t know about that justifies the need to refinance.
Reasons not to refinance: #4 – Funding a get-rich-quick scheme
I am all for investing. If you have a lot of equity sitting in your home doing nothing, there are definitely better uses for that money. Investing in real estate and / or the stock market (long-term, not short-term gambling on options or an earnings season) is a great way to create wealth and help you meet your retirement goals. I advocate the idea of investing in both real estate as well as the stock market because diversification is good and both of these investments have different advantages. I would absolutely recommend against taking equity out of your home to invest in something that isn’t proven.
Reasons not to refinance: #3 – To purchase non-appreciating assets
This one can get a little sticky. If you are trying to play Keep-Up-With-the-Jones by upping the ante in the neighborhood movie club by installing all the latest theatre equipment, a bunch of recliners, and new furniture in other rooms because now the new furniture in the new theatre means that the rest of the house also needs new furniture, then this is a recipe for financial failure. The assets in this scenario are all depreciating and paying the cost to refinance to buy depreciating assets does not make good financial sense. However, if your home is out-dated and in need of a remodel, refinancing to take out money to redo the kitchen, master bathroom (and other bathrooms), install new flooring and other such improvements can be a great way to increase the value of your home. My wife and I have performed major remodel projects on every home we bought including a huge remodel on our current home that included expanding the master bath, moving the laundry room upstairs, adding a room int he basement, installing new carpet and wood flooring throughout the house, putting in a new garage door and opener, and painting every room. The increase in the value of our home is significantly more than the cost of doing these things AND we get to enjoy our home much more because of what we did.
Reasons not to refinance: #2 – To lower your rate
At first blush, you might think I’m out of my mind by saying you shouldn’t refinance to lower your rate. The truth is that chasing rate is not good. I’ve seen people who have chased rates by refinancing several times in a declining rate environment with minimal gains and new costs for each refinance. If your rate is high relative to current rates, it might benefit you to have an honest conversation with a good mortgage professional to see how much you could save if you refinanced but it’s also important to consider other things like how much longer you plan on living in your house – if you plan to move in a time that is shorter than the break-even period for refinancing, then it doesn’t make sense to refinance. You may also consider things like taking equity out of your home for investment or remodel purposes rather than just refinancing your current mortgage to lower your rate and payment or consolidating debts to help increase the amount of cash you have that can go toward investments each month. If you refinance just to lower your rate, the most important thing is the payment savings and the break-even period, not how much you lower your rate. A bigger loan typically won’t need as big of a rate reduction for a refinance to make sense as a small loan does, but it’s all dependent on your personal situation.
Reasons not to refinance: #1 – To go on vacation
Don’t get me wrong, I love to travel and explore the world and memories do last a lifetime – but they don’t pay the bills or help you retire. I’ve had a lot of clients who talked with me about refinancing so that they can have the money they need to go on their dream vacation. I always recommend against it. That said, if you refinance and take out a bunch of money and do some great things with it like a remodel or, better yet, purchase an investment property, if you take out a bit more to go on a reasonable vacation, that’s not the worst thing you could do – especially if you could do it in such a way that you could write it off. Maybe you could attend a seminar on real estate investing that’s out of state in a place that would be fun to visit, or maybe the investment property you want to buy is in a great vacation destination so that every time you go check on your investment property, you can take a vacation and write it off (check with your tax professional to make sure you are complying with the current tax laws).
There are a lot of valid reasons to refinance but there are also a lot of bad reasons. Sometimes the reasons are very personal – you need money to pay for a much needed operation or to pay for your kids’ college. Whatever the reason may be, it’s important to speak with a good mortgage professional who can advise you with regard to your options, run some numbers for you based on each option, and be a sounding board for you. In some instances, like in the case of buying an investment property, you may want to involve a Realtor, or a financial planner / advisor when it comes to investing in the stock market. If you don’t have a trust, you should consider consulting with an estate planning attorney about setting up a trust and the benefits it would have for you and your financial situation.
Contact me at (702) 812-1214 or (801) 893-1737 if you have any questions regarding refinancing or investment property strategies. You can also get lots of information regarding real estate investing by watching my 6-part video series on real estate investing.