In the past, a refinancing homeowner cashed-out some of his appreciated equity, refinancing so he could borrow money to spend on consumer goods or other investments. The recent trend has seen a large number of homeowners now adding cash to their mortgages in order to refinance at current low interest rates, in order to pay off their existing mortgage and create the minimum equity required by the new lender.
As a result of the recent drop in home prices, many homeowners are underwater financially with negative equities on their homes. Due to the ultra low 4.75% 30-yr fixed mortgage rates, a third of all borrowers in the nation who refinanced during the fourth quarter of last year put cash into their homes to help pay off the existing mortgage. The percentage dropped during the first quarter of 2010, but Freddie Mac’s chief economist is confident the number of refinancing homeowners that add cash to help pay off their old mortgages will remain high through the rest of this year.
first tuesday take: Freddie Mac’s chief economist claims by adding the cash necessary to pay off the balance of the existing mortgage not funded by the refinancing, the homeowner will get a better return on his money— which makes no sense whatsoever. Using one’s cash reserves to pay down a mortgage that exceeds the value of the property is worse than burying money in the backyard and hoping to find it again twenty years from now.
Investing good money to cover “sunk costs” (bad money, which is unrecoverable under any circumstances, as is the negative equity position in a home) is a fool’s game. This is especially germane for a homeowner who can keep the money in his wallet, add to it by living rent-free for a year and legally walk away from the underwater purchase-assist mortgage without liability.
Having witnessed the housing bubble implosion, homeowners have learned that putting money into any property is never guaranteed as a safe investment — but they now need to realize that putting money into an underwater property is a guaranteed loss.
It is better for the negative-equity homeowner to talk to his real estate agent and make plans to either buy an equivalent home during the next two to three years or to buy one now under contract with an investor. [For more information on cash-in refinancing, see the February 2010 first tuesday article, Homeowners buy-down mortgages with cash-in refinancing.]
Re: “‘Cash-in’ refinancing lets underwater homeowners take advantage of low interest rates” from Los Angeles Times
A home is a utility, not an investment. It is something you utilize. The question is one of the value of shelter.. Homes historically have not appreciated with any great movement. Houses tend to keep up with inflation. Hence, a moderate increase in value. The person that did this article should do their homework.
Heather,
I agree that if borrowers are bringing money to close when they’re way upside down, that’s a fools game.
But, there are still millions of homeowners with equity. And in some cases, bringing a few grand to close (or even $50k) to bring their balance down to a level where they can increase their equity, and drastically cut their cost of funds, can pencil out very well.
In fact, I’ve a scenario right now that goes like this:
$800k value (conservatively, probably $825k, but… I like to be conservative)
$665k 1st at 6% 5/1 ARM, p/i that has 2yrs until 1st adjustment
$80k fixed 2nd
By paying down the first balance to $625,500, we can do a no points no fees loan to 4.875%. That saves my client $800/mo.
Projecting forward to August of 2015, if he kept his current loan, his principal balance would be roughly $407k.
With the new loan, it’ll be roughly $375k, but, we have to add the $40k brought to close to that figure, so…he’s at $415k, compared to $407k balance if he did nothing. However, during the next 5yrs, that $800/mo savings totals $48k.
So, in 5yrs, he’s got more than his $40k back, AND cut his principal balance by $40k more than had he done nothing. Plus, my comparison assumes that his ARM will average 6% for 3yrs after the first adjustment. Although we could be in a low interest rate environment for a lot longer than people think, we could also hit the debt wall, and see rates rise pretty quickly in a 2-3yr horizon.
Now, in this case, the only rub is that they’re not sure they’ll be there for 5 years. They think so, but…that’s reason for pause.
And, this is an extreme example. Most of the people I’m working with, where it makes sense to pay down their existing balance a bit, are only off of an LTV mark by a few grand. In that case, it can indeed be a very cost-effective way to go.
You can’t go wrong with debt reduction (unless you’re way upside down). It’s a guaranteed return. You can’t get that type of return, particularly accounting for risk, in any other investment vehicle.
Actually, it depends upon the homeowner’s situation; if they are planning to hold the property for long term and not sell within the next 5-10 years, it may make sense to pay cash in to a re-fi situation if they are only moderately upside down. This is especially true if they are facing an interest rate adjustment or conversion from interest only to fully amortized and have no intention of selling or walking away.