With Interest Rates This Low, More Looking to Refinance
Depending on the circumstances, it can always be a good time to refinance your mortgage. Today’s low rates make this even more tempting, but we need to be careful.
There never seems to be a shortage of what we could call refinance bears out there, those who seem to forever want to caution us against these things and take a much dimmer view of mortgage refinances than more careful consideration would warrant, even tossing the idea at the pre-cognitive stage.
These folks are coming out of the woodwork again as lower mortgage rates are causing people to want to do more of it, for a variety of purposes, some very good and some not so good. Mortgage refinancing is a powerful tool that can be used to help us enjoy our lives more without coming at the high price that unsecured borrowing comes with, especially using credit cards.
As is the case with any form of borrowing, you can still overdo it, even though mortgage lending does come with much stricter controls on capacity than credit cards do. What makes using high interest credit cards so dangerous isn’t even their high rates, it’s the dangerously low lack of capacity that they tolerate, where utilizing the amount of credit that they grant can take us well beyond our ability to repay the debt even without any incidents that reduce this ability.
We need to not make the mistake of equating borrowing by way of tapping into our equity as being an evil in itself, as the real culprit here is the tendency to overborrow. This knife is actually much duller than the other ones in the drawer, especially the razor-sharp ones that are credit card companies provide us.
There is a certain capacity that will be accounted for with secured lending, which is very much dependent upon our income, rather than the way that credit card companies manage this, by not taking our ability to pay into account very much at all. Their high rates are designed to take on a lot more risk, and they can therefore take this up quite a few notches before they get to the threshold that really concerns them.
Non-credit card unsecured lending, like personal loans and lines of credit, also use capacity as a fundamental criterion, at least at banks, and lenders will keep us pretty much in line with our capacity provided that game-changing events do not occur, such as job loss or a major unexpected expense. We cannot pretend that these things never happen to us though, because they might, and to the degree that we are exposed to these risks, we should have a back-up plan that at least looks to reasonably manage this.
For those who have enough debt to need to do such a thing, they likely do not have much disposable savings, so this plan is going to involve having access to more credit if needed, the sort of thing that a line of credit is good for. This can keep things together if trouble does surface, and while we can never protect ourselves against all risks, we do want to at least make a good effort to do so, especially if we can do so rather easily.
If we have enough home equity built up that we can qualify for a home equity line of credit, this can serve to keep this equity in reserve to be used as a safety net, and this is a safety net that we may indeed need some day. Just knowing that you can handle things like losing your job and manage to keep up your payments provides value and allows you to rest more easily than those who are a couple of paychecks away from being taken down, and this includes a great number of people.
This is not the time you want to be looking to apply to borrow, as your capacity has taken a huge hit and you just won’t qualify. Lines of credit can be used in good and bad times, if you have them in place that is, and they also don’t require payments and you can draw from them instead if you need to, unlike loans which always require regular payments.
Choosing Between Different Types of Refinancing
We are often faced with a choice between refinancing our mortgage or going with a home equity line of credit instead, and they both have their own particular purposes, so it’s important to have a good understanding of the strengths and limitations of each prior to deciding.
The advice that we may get may not be all that sound though, and this should not be a matter of just reading some articles that others have written, and going with their advice or even letting it influence you in many cases. This is not rocket science and just being aware of a few simple principles is all you really need, although we may wonder how they may have escaped the thinking of some of the people who profess to be experts on this.
The place to start our deliberation though is always at the level of whether we should borrow or not, and overborrowing can actually be considered to be a disease of the mind, and a disease that is pretty widespread. Increasing your buying power can be pretty tempting indeed, and it is very easy to give into the temptation of the benefits of this without considering the costs carefully enough.
We never want to say that leveraging your home equity by either using a cash-out mortgage refinance or obtaining or extending a home equity line of credit is always a bad thing, even though there are folks that may want to talk you out of it without considering the circumstances.
It will always come down to the purpose, whether it is worthy or not, and then compare this to the costs, including any added risk that it involves. Some, like Karim Ahamed, a financial advisor at Cerity Partners in Chicago, advises forbearance in our later years “so you don’t have the millstone of a large mortgage around your neck in retirement.”
This does bring up a good point, and we always want to look at our capacity in retirement and this can indeed shape our earlier decisions. It’s not the size of the mortgage that matters though, as you can amortize your mortgage many years beyond your lifespan by simply pushing it forward.
The payments that you need to make definitely matter though, and if your future income does not support it, or if it causes you to need to cut back your lifestyle so much that you will endure too much hardship, then you are just setting yourself up for failure. In these cases, we want to be spending our equity on the line of credit side of things, as lines of credit don’t really have required payments and in a pinch, we can even further amortize some of our mortgage payments, since lines of credit debt does not ever need to be amortized.
What this means is that if you do need to borrow, let’s say you have a lot of debt that is at a higher rate than you could get with home equity lending and you should be doing something here, adding this to your mortgage might not end well because it might be too hard to manage one day, where putting it on a line of credit wouldn’t really add to your burden as long as you have enough room on it to just push it forward as well, but push the entire obligation in this case if needed.
It’s Just Better Not to Borrow Too Much, Either Then, Now, or Later
The best scenario would be to not have accumulated all this debt that is now subject to the opportunity for a lower rate, where we get ourselves in trouble by overborrowing for things that we really don’t need and then look to get bailed out by a refinance. However, after the fact, we now need this help, and while we may or may not have learned our lesson, we need to look forward and seek out the best remedy.
This can happen at any stage in life, even though we normally think of these mistakes as mostly being made by younger people who are more in need of self-education.
People of all ages overborrow, even people in retirement, and we do not want to forego correct choices just because we are of a certain age or situation. This all will be accounted for as we genuinely pursue the right path, and when everything is accounted for, refinancing sometimes does win out.
As is often pointed out, mortgages have lower rates than home equity lines of credit, so we generally want to refinance debt by adding it to your mortgage, but not always. If we can only choose one or the other, it may be worth it to pay the little extra interest with the line of credit if its added flexibility makes it worth the extra cost, and often times it does.
If, for instance, you owe a certain amount of debt and if you put it on your mortgage, this will tap out your equity, and you expect to need to borrow more, which most people do, then being able to pay it down on a line of credit to be re-used later can be a better plan. Any future borrowing needs should always be covered by a line of credit though, as we don’t want to pay to hold cash for very long like we would if we put it on the mortgage.
There are hybrid products which offer the flexibility of being both a mortgage and a line of credit, and these can be great choices, and the trend is toward this sort of product even though this trend is growing very slowly these days. This is a product that makes a lot of sense to a lot of people, and serves to turn the mortgage part itself into a line of credit, with the equity paid down on it transferring to the credit limit of the credit line.
A big concern for many people is the risk involved in adding debt to your home, and this does add to the risk of losing it. We need a hard wall to protect us against such a thing, and just like we would not want to go without fire insurance on our home, we need to make sure that we have a plan to protect it from burning down financially.
This does not mean just say no to refinancing though, and far from it. The wall we need here is the one that makes sure we can meet our secured lending obligations no matter what, but as long as we stay within this, we should never want to use our fears of default as an excuse to avoid situations that would be of benefit to us overall.
Tom Frederickson, a financial planner with New York’s Garret Planning Network, warns us that refinancing could see us losing our house. While that is true, and this is also something that we do want to prevent, we don’t want to be ignoring the area between where we are standing now on our lawn and this wall at the end of the property, and this is far from a reason to just stay out of the backyard.
Since our homes are on the line, secured lending payments should take priority, where defaulting on unsecured debt even to the point of bankruptcy has lesser consequences. We do need to realize though that when things go so wrong as to have your home foreclosed on, it is already in such a state of disrepair that we’re just walking away from rubble anyway.
This is therefore not quite the tragic event that we may think it is, the losing the home part after we have depleted what it is worth to the extent that it basically becomes worthless. We don’t really lose much equity in these situations, as we have already spent almost all of it, and there isn’t even enough left to even string things along anymore.
The specter with foreclosures therefore isn’t really that much worse from a financial standpoint at least than an unsecured bankruptcy, although it surely is from a psychological perspective. We want to be managing psychological issues as well, but we do need to be clear on the actual contributions of each to the problem to be in a position to properly evaluate this risk.
Frederickson does bring up the important point of looking toward the expected payback period to decide whether to use a mortgage refinance or a home equity line of credit to pay off the amount, although this opens up a bigger can of worms.
Even if you are planning on paying off the amount in 5 years or less, the line of credit isn’t actually the best plan generally as Frederickson believes. All you need to do is commit to using your pre-payment privileges to make extra payments to your mortgage to amortize this debt over the desired length of time and you can enjoy the lower interest costs of this.
This does require commitment though, a quality in short supply with a lot of people, especially those who have gotten themselves into such trouble that the costs of a refinance become justified. In these cases, the line of credit will make this debt much more transparent than burying it in your mortgage serves to.
This brings up the number one danger of mortgage refinances though, which occurs at any age or circumstance, which is the tendency to approach these refinances as stuffing things under the bed, which cleans up the room and allows you to have more fun but is potentially headed for trouble.
This is the number one reason by far why so many people tap out their equity and get in trouble, and while this doesn’t usually mean default risk, it sure can mess up the rest of your life. If your mortgage payment only goes up a little and your total payments become significantly reduced, we may not realize that we’re paying back what was short-term debt with longer-term debt that can really accumulate under our beds.
Eventually, we may still borrow like there is no tomorrow, and the tomorrow then ends up creeping up on us more and more as we keep refinancing and adding to this future burden. This is what governments do, but they can get away with it for a lot longer than we can, where we may live to see our speeding car hit the tree, where with governments, this may be several generations away.
This is where the too big to manage payments in retirement really come from, and the only real way to manage this risk is to seek to pay off refinanced amounts over more sensible time frames, like using this to buy a car and paying it off in 5 years, not 30. There will be more cars and eventually you will be paying for many at the same time, for a long time, if you abuse this.
Eventually, there is no more room under the bed, and as the room clutters more and more, there is nowhere to put all that stuff, as we have used up our reserve space under our bed. People will tell their kids not to do this but they do the same thing, with much higher stakes.
We may need to exceed this normal payment time threshold, but this should be confined to exceptional circumstances. While it is a benefit to save interest, extending the loan far too long can turn good to bad and should be avoided whenever possible.
Overborrowing in general can get us on a track where it does become necessary, when we reach the point where we can no longer pay off what we have borrowed in the normal time frame, leaving us no choice but to extend the payments on it for up to several decades.
This is the part of the mountain that we need to steer clear of, as it is the tipping point where we now are risking falling off. We do not want to have the temptation of 30-year amortizations with our everyday borrowing add to this problem, for the same reasons as our not wanting to exceed our capacity with unsecured borrowing, because this is just asking for trouble.
It always needs to make enough sense to borrow to want to do it, and we should not see our home equity burn such a big hole in our pockets that we treat it as found money. Other than that, tapping into our home equity can be a wise choice, but to tell what is wise, we have to think more wisely.
Editor, MarketReview.com
John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.
Contact John: john@marketreview.com
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