This time around, we’re going to cover my favorite reason to refiance your home… to make some freakin’ money!
In this case, we’re not actually creating a new mortgage, we’re just pulling some money out of the equity you have built up on your mortgage over time. Why would we want to do that? Because your home mortgage is going to be some of the cheapest money you will ever have access to.
But wait, isn’t that risky? What are you supposed to do with money that you’ve borrowed at a rate of 3.5-5%?
Well, beat that rate of return, for a start. But don’t worry… I’m not suggesting putting that cash into stocks or anything. That implies a great degree of risk. Last thing we want is a 20-40% chance that some or all of the money you pull out of your mortgage is going to go up in smoke.
So what do we do with the cash? If you’ve been reading this blog for any period of time, you know that we’re big fans of “Fed Watching”. The American Federal Reserve is the world’s largest bank, and they’re charged with making sure that the American (and to a smaller extent the world) economy doesn’t accidently jump off the top of a skyscraper. Sometimes, that means they end up bailing out asset classes like US bonds, or their current kink, mortgage backed securites.
As long as the world’s largest bank is snapping up mortgage backed securities, they are pushing up demand as well… which effectively places a backstop on the price movement of these securities. There would need to be a hell of a housing crash before these securities start going down in value.
The best part? The interest rate you collect can often be over 7%. Pay 3.5% interest to your bank, collect 7% from other people’s home mortgages owned through securities backstopped by the world’s largest bank? Sounds sexy, doesn’t it?
Last post, we covered how to refinance your home.
With a reduced interest rate, you have the ability to either pay down your mortgage at the same speed as before but with a lower payment, or (the much smarter alternative in our opinion) you can keep the same payment, and pay off your mortgage much, much faster.
So why isn’t everyone refinancing their mortgage everytime that the Fed announces they’re pushing back their interest rate hike schedule? Two reasons… one, the average Joe is not interested in the slightest. TV news refuses to cover it, because important events directly affecting your life isn’t their job. Getting eyeballs on advertisements is. Which means down with Ben Bernake, and up with Lady Gaga.
The second reason people aren’t refinancing left, right, and center is that your mortgage almost certainly came along with an early payment penalty. If it didn’t you would almost certainly have been penalized with a much higher interest rate, which you wouldn’t have accepted. When you refiance your mortgage, you are not simply changing the terms of your current mortgage, you are paying off your current mortgage and beginning a new one, which will incur your early payment penalty, which is in the thousands of dollars range.
So when is it a good time to refinance and eat the penalty? When you can reasonably expect to make back the money on the penalty via reduced payments within a few years. It takes a little bit of calculator time to figure out, (If my payment reduces by $100 per month, that’s $1200 a year, it will take 3 years to pay a $3600 early payment penalty) but it can definitely be worth the effort.
Another reason one may wish to refinance their mortgage is to consolidate debt. If you have $10,000 of credit card debt that you’re paying, for example, 20% interest on, then that means that you’re paying $167 in interest every month, before you even touch the principal. Ouch! But if you roll that debt into your home mortgage that is being charged at, say, 5% interest, that $167 of monthly interest becomes $42.
Wow, that sounds great! So what’s the drawback? Well, the $10,000 of credit card debt in the first place. How did that happen? If it was for a one-time expense like a medical bill, no problem.
But if that debt was racked up by a big screen TV or a 2 week vacation, you’ve got a leak in that wallet. In which case, refinancing isn’t going to help. The most common scenario in this case is that $167 payment goes down to $42, exactly as planned. But then another vacation creeps into the mix before the debt is paid down. A new video game system is released, and new games to go with it. Aw! Look at that puppy in the pet shop!
Next thing you know, that $10,000 credit card debt has reared its ugly head again, and now you have an extra $10,000 of mortgage debt to boot! So instead of $167 down to $42 a month, you’ve gone from $167 to $209!
The solution to this is to cut up that credit card and not apply for another one. Anything shows up in the mail that feels like there’s another card inside gets thrown out without being opened. But even that is only fixing the symptom and not the underlying problem. We would highly recommend getting your financial house in order (become accustomed to spending less than you earn) before refinancing your home to consolidate debt.
This post will be the beginning of a series that examines whether or not it is wise for you to refinance your mortgage.
First things first, why on earth would you want to do such a thing? Well, there are several good reasons, and the best of which is to reduce your interest rate.
If your mortgage is fixed rate, and more than six or seven years old, you are probably paying a lot more in interest on each payment than you could be. The general idea is that if you can save two percent or more on your interest rate by refinancing, it is worth the time and effort to do so. A lot of finance outfits now recommend that a reduction of 1% is enough of a cut to refinance, but obviously we shouldn’t go around blindly trusting guys that get don’t get paid if you don’t refinance with them.
But there are real reasons why that rule of thumb is dropping. As we have covered in this blog previously, the Federal Reserve has dropped interest rates to an all-time low. They have also gone on record as stating that they plan on keeping rates unchanged for a long time to come. (hellllo, Japan!) That means that a large part of the short term risk inherent in using variable rate mortgages (you pay a lower rate now, but if interest rate rise, so does your mortgage rate) has been removed.
So that means you can save a lot on your interest rate if you refinance your mortgage now with a variable rate for 5 years. It requires a little vigilence on your part because you and only you will be responsible for keeping track of when to pull the trigger. Never expect your bank to look after your interests in this regard, because your gain is their loss.
Thought: As people are ever-increasingly fearing for their jobs in the US, it strikes me that those still hanging on are now doing much more work (to take up the slack from the downsized positions), and spending more time in the office in general. Fear of getting the axe would do that to you, I’m told. (I don’t actually know. I’ve never really worked a “real job”.)
If they’re spending more time in the office or bringing their work home with them, that means less time for everything else… like cooking. I would expect that in tough times, cheap, fast food becomes more and more popular. Which makes fast food probably a sector to invest in that would outpace the market. I don’t think the sector would be a world-beating sort of play, but it should deliver good steady growth for some time to come. If everyone wants to stay on the Big Mac Express, no reason why I shouldn’t be getting a piece of the fares.