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Is the cash-out refinance for investment a good use of your home equity? There are several times it might be:
- A cash-out refinance to fund investments can work if you have enough retirement and emergency funds
- The cash-out refinance to invest in a new business could provide smart emergency cash flow, because by the time you actually need back-up funds, you may not qualify to borrow them
- And cash-out refinancing to buy a new property may be the cheapest way to get your down payment, closing costs and other funds
Numbers don’t (usually) lie. Here’s how to determine if cash-out refinancing is the safest and least expensive way to accomplish your goals.Verify your new rate (Jan 24th, 2020)
Cash-out refinance for investing
Cash-out refinancing simply means replacing the mortgage you already have on your home with a bigger one, and taking the difference in cash. You use this extra cash to fund your investment.
Cash-out refinancing usually costs more than rate-and-term refinancing, but less than most other methods of borrowing.
For example, Fannie Mae adds surcharges ranging from .375 percent (for someone with an 740+ FICO and a loan-to-value after refinancing under 60 percent) to 3.125 percent (for someone with a FICO under 640 and refinancing to an 80 percent loan-to-value).
This is an important consideration, because that fee is based on the entire loan, not just the extra cash. Cash-out underwriting guidelines are stricter than those for rate-and-term refinancing.
Always compare the cost of a cash-out refinance (including upfront fees plus interest for as long as you plan to have to loan) to home equity loans and even non-mortgage options like personal loans.
Cash-out refinance for stock investing: cons
For many people, a cash-out refinance to invest in stocks carries risks that might be too high:
- There is no guarantee that investments will increase in value in the short-term. If you need the money soon, you could have to cash out your securities and take a loss
- The cost of cash-out refinancing is higher than rate-and-term refinancing. If you only get a little extra cash, you’re paying a surcharge on the entire loan amount, and that can be an expensive way to borrow
- By refinancing your mortgage, you’re extending the repayment period, and that can cost more over the life of the loan, even if you get a good interest rate
- If you can’t keep up your higher payments, you could end up in foreclosure
Bad example of cash-out refinance to invest in stocks
The Smiths are in their mid-50s, hoping to retire in about six years. Their home is worth $400,000 and they owe $300,000 against it after 11 years. They have good credit with a representative score of 720. Their current interest rate is 4.25 percent and they want cash out to invest in the Us stock market, which historically pays about 10 percent.
They note that refinancing to $320,000 at 4.5 percent drops their payment from $1,968 to $1,621, but that’s obviously not due to a race decrease (the new rate is higher). It’s because they’re starting their repayment over, and it will add 11 years to their mortgage repayment.
There are many reasons that cash-out refinancing is a bad idea for them.
- Today’s mortgage rates are higher. They may be able to do better with a 15-year loan if they can afford the higher payments
- The maximum they can likely get with a non-government loan is $320,000, about $20,000 in their pockets after refinancing. That’s not much, considering the cost of obtaining it
- Their cash-out pricing adjustment at their FICO score and LTV is 1.125 percent, or $3,600. $3,600 divided by $20,000 is 18 percent. That’s an 18 percent upfront cost in addition to your interest. Very few stocks can be counted on to return 18 percent
- They plan to retire relatively soon. If the market goes south, they have less time to make up their losses
- They added 11 years to their repayment. And 11 years of paying $1,621 a month adds over $200,000 to their costs. Very few $20,000 investments can fill a hole that big
Cash-out refinance for stock investing: pros
The cash-out refinance to invest in stocks works well for those in position to take advantage of the pros:
- If your income is solid and expenses low, you’re less vulnerable to stock price drops
- If you’re young, you can more easily ride out the ups and downs of stocks
- The cost of borrowing may be lower if you can deduct your mortgage interest
- The average return on stocks since 1926 is 10 percent, according to Forbes, while mortgage rates are ranging between 4 and 5 percent as of this writing
- You can overcome the problem of extending your repayment if you choose a loan with a shorter term or make additional payments retire your loan on time
- Investing and also paying your mortgage is one way to “force” you into more retirement investing, especially if you direct the money into accounts you can’t easily withdraw from
Your mortgage is what’s called “forced savings” which pushes you to acquire home equity as you repay your loan. That is often the primary way that less-affluent homeowners acquire wealth at all. And why homeowners enjoy $197,349 more savings than renters, according to a 2017 Census study.
Adding that to another form of retirement, like stocks, could improve your future wealth.
Good example of cash-out refinance to invest in stocks
The Washingtons also own a $400,000 home. But they are in their 40s and plan to work another 20 years at least. And they owe just $200,000 on a 30-year FHA mortgage, but cannot drop their FHA mortgage insurance, so they are paying 5.5 percent including their mortgage insurance. They also have excellent credit and want to borrow an extra $100,000.
A cash-out refinance to invest in stocks might be a good strategy for them.
- They can improve on the terms of their original loan by dumping the monthly MIP premiums
- The amount of cash-out is relatively large, so the added fee is proportionally smaller
- They are in no hurry to leave the workforce and can ride out a bad business cycle
Their 75 percent LTV cash-out loan has a cash-out surcharge of 1 percent, or $3,000. That’s 3 percent of their $100,000 for stock investment. A lot better than 18 percent.
Cash-out equity from one home to buy another
You can use cash-out refinancing to purchase a second home or rental property. That means taking enough extra to purchase the whole house, or just to make your down payment, closing costs, and beef up your emergency funds to make you a stronger applicant.
You’ll put the extra cash in your bank or investment accounts, and eventually use it to buy the rental or second home. If you purchase the property outright, the seller won’t care where the money came from. You can just pay and receive title to the home.
But if you need a mortgage to buy the second property, you’ll have to be careful. Most, if not all, non-government mortgage programs require you to contribute a minimum percentage of your own funds. You don’t get to just borrow your down payment. And government loans don’t let you buy vacation or rental homes.
So any cash-out that you get from a refinance needs to hang around in your bank or investment accounts for a while, until it becomes indistinguishable from your other money. This “seasoning” takes a few months. At that point, you can apply for a loan on the new property, listing all of your account balances as assets.
You’ll also disclose your refinance payment and your other debts in that section of your mortgage application.Verify your new rate (Jan 24th, 2020)