The couple receiving a Money Makeover are both in their 40s, make $120,000 per year, have $100,000 in their retirement accounts, and a considerable amount of equity in their home. They currently have an adjustable rate mortgage. The couple describes themselves as "risk-adverse".
The Money Makeover suggests that the couple take out a new $500,000 ARM to pay off their existing $300,000 ARM and put the extra $200,000 in the stock market!
I can hardly believe this advice. Worst case scenario is that the value of their house drops considerably while rates rise and the value of their investments drops. Historically, this has happened before. In this scenario, they could be stuck with a skyrocketing ARM and mortgage payments that they can't afford, or have to refinance with undesirable terms.To be sure, borrowing against a house to put the proceeds into the market rarely makes sense. But in Handel and Laport's case it does because so much of their net worth is tied up in their home, and the super-hot L.A. real estate market looks primed for a fall.
They can convert equity that might melt away. And with a $500,000 mortgage, even if the L.A. market drops 30 percent, they would still have substantial equity in the house, which they hope to sell in five to seven years. "This is very aggressive," says Van Slyke. "For them to catch up, they've got to be unconventional. Over time, their investments should grow by more than the interest rate" on their mortgage, which should be under 6 percent.
Why not have this couple refinance to a fixed-rate loan, reduce their other monthly expenditures, buckle down and start saving some money? I would think it would be advisable to try to start reducing expenses in order to save now when it is voluntary rather than later when the payments on their $500,000 ARM mortgage go up $1,000 per month due to increases in the interest rate
Even I remember a time when mortgage interest rates were at 14%, and real estate was a poor investment. I can hardly believe that the experts at Money magazine have forgotten.
11 comments:
I read the article yesterday and had about the same reaction as you did.
Its always better to educate yourself so the "experts" don't lead you down the wrong path.
Saavy, Although I am dubious on the ARM aspect, I find this advice to be on the money-no pun intended. IMHO, cash out refis, at this time, are a smart move, provided that you reside in certain geographical locations. I do not know enough about the L.A. r.e. market to comment on it. Having said that, mortgage rates are still at or near historic lows, therefore you can cash out using cheap money (and tax free), with minimal transaction costs, and use the cash for a higher return investment which, for me, is not the stock market but investmnet real estate. To presume that your principal residence will continue to increase in value to the extent it has in recent years (in my case, I have over a 700% paper ROE in one year) is faulty, thus it is a good time to use the equity to put into a higher returning vehicle (just like profit taking in the market only you dont lose ownership). Let me give an example of why this is not necessarily bad advice, the equity in my principal residence has increased in excess of $150K in the last calendar year. This increase is not a "bubble" as every know nothing yahoo pundit likes to term it, but is rather an upward revision based on historical underperformance of the real estate market in my area. I can cash out refi today for 80% of the new appraised value, thus leaving me a 20% cushion for downward revision in real estate values. The proceeds of the refi can be used to purchase an income producing multi-unit property which, assuming proper managment and careful selection, will increase in value so that, in 2-3 years, i will cash out refi that property based upon the increased appraisal and so forth and so on. Therefore, advising someone to cash out refi on their principal residence, even into an ARM, assuming knowledgable persons, is not in itself bad advice. I would not advise them to use the proceeds to put in the stock market, but thats me. If these persons are good stock pickers, then thats different. This is one approach to increasing wealth. Another is to stash away every last W-2 cent and dollar cost average for 30 years into the market. Full disclosure: I live in the metro NY area so r.e. values should remain steady. I would be dubious about doing this in an area where income levels cannot support sustained r.e. value increases.
btw, mortgage rates haven't been 14% since the very early 80s.
Cash-out refi's aren't bad in themselves. Cash-out refis with ARMS when rates are very low are not a good idea. Cash-out refis when you have a good chance of a down-ward trend AND expect to sell in the next 5-7 years is also not a good idea.
Experts? Probably needs a new definition.
I am not an expert but in full agreement with bored. How about starting the next year at "0" Zero debt? Considering that fiscal growth can also be gained by reduction of debt.
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"Cash-out refis when you have a good chance of a down-ward trend AND expect to sell in the next 5-7 years is also not a good idea."
that statement may apply to some but certainly not all. Theoretically, even if you were to take a loss on the sale post refi, you had access to the money beforehand (optimally for the full seven years), thus optimizing the time value of that money. Therefore, as the rates rose and values dropped (in your theoretical case), the cash you refi'd out on is earning a higher rate of return than it would have lying dormant in paper equity (in fact, that cash would disappear). Moreover, in my case, i see no reason of a downward r.e. trend (again, thats area-specific and may be different in your neck o of the woods) as i live in a historically undervalued, recently renovated building in a high income part of the country.
Using your house as an ATM is not the same as cashing out when the market is good. When the tech stock market hit its peak, it would have been wise to sell the well-performing stock, not take out a loan against its paper value. People are seeing the value of their houses peak and are borrowing against it. The real way to leverage that equity would be to sell. If the market tanks, not only do you still own the property that is declining in value, you owe money on it.
I know real estate is different and people still need to live in their homes, but borrowing against something just because you can (or can't afford not to), in itself is not a good reason to do it. You have to remember, this expert recommended taking a secured loan on their home, with a variable interest rate, to invest their money in a place they could potentially lose some of it.
I thought the advice was reasonable (except for the ARM part). This couple has a net worth of about $800K. 700K of that is tied up in their house. It makes sense to pull some of that money out to diversify.
I agree with Savvy Saver, taking out a $500K ARM seems kind of crazy. At its worst, the LA market crashed about 20% with a 10 year recovery period. a 20% drop on a $800K home is $160K. If this couple had to sell during a crash, they'd walk away with $140K, instead of $500K.
I understand diversifying, but why didn't they recommend the couple take out a $300K 7/1 or 10/1ARM (which are P&I only at a lot of banks) refi and lock in a lower rate for another 7-10 years? The advisors or article neglected to talk about interest rate movement, because that's what this strategy banks upon.
If you're risk averse what's the recommendation? They cash out the equity in their house and buy CD's & bonds the the next few years?
Financial advice - Anybody can have great such ideas with other money. I wish these original articles has a feedback forum. Well on a second thought, that would only encourage them.
Mapgirl,
I think your numbers are wrong, but you've hit the nail on the head as far as misunderstanding this strategy.
When the couple borrows an additional $200K they are investing it somewhere. It is true that IF the house drops in value by 20% and they are forced to sell at 800K instead of 1 million then they will only get $300K instead of $500K. But they still have that $200K invested somewhere. At the end of the day they still have the SAME net worth.
One argument against this strategy is that the stock market will not provide enough return to beat the interest rate they are paying to borrow more money on the ARM. The other argument is that the ARM payments could increase over time and become unaffordable. Those are both valid fears, but in my opinion they are just that - FEAR.
Absolute worst case scenario they could still sell their house, move to somewhere less expensive, and pay cash for an entire house.
Balance that against the reasonable chance that their mortgage remains affordable and that the stock market beats the interest rate.
Actaully the concept might just work for them. But instead of the stock market the take the 200K and purchse real estate in the starter home price range or even a foreclosure. Caution though, the a buyers market is creeping back.
However, cash stream from a rental or an owner financed re-sale may just offset interest costs and provide a windfall on closing. Tax breaks are available for qualified properties. Many gains there.
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