To Cash-Out Refinance And Make It Rain…. Or Not
Rainy Day At Peterhof Palace, St. Petersburg
Lots of cash buys you lots of alcohol, access, and action – Triple AAA if you will. What more does anybody want?
Let’s say you’re on a hot date and roll up in the Corolla to your favorite five star restaurant, Olive Garden. You slip the valet a $5 for the $4 valet fee and tell him to “keep the change” so he can keep it up front.
The hostess greets you coldly and says there’s no table. You pull out another crisp $5 dollar bill and she changes her mind and seats you right away. Normally you just order water, but tonight you get a little crazy with $3 Bud Lights! And afterward, since you two are all tipsy now, it’s Nintendo Wii action all night long!
Now that’s Triple AAA.
THE TEMPTATION OF CHEAP MONEY IS STRONG
Triple AAA is tempting me right now as I consider doing a cash-out refinance for one of the rental properties at 3.375% from 4% (thank you Ben Bernanke). If you’re in a oppressively high federal income tax bracket, you might consider doing a cash-out refinance to lower your income tax bill.
Since I’m pretty sure I’ll be in a lower income tax bracket during retirement (as will you most likely), I figured why not extract cash out of a rental property and increase my interest expense to shield my rental income. With 5-year rental property money at only 3.375%, it would be foolish not to at least consider the option.
The rental market is hotter than the 49ers and I was able to increase my asking rent price by 12% last month from a year ago. My realtor friends implored me to raise the rent by another couple hundred bucks, but I didn’t have the heart since I had already put the price out there on Craigslist, and I found a potentially ideal tenant.
By refinancing, the cash flow for the rental property increased by another 23% for a total increase of 35%. Yet, despite this increased cash-flow, I thought long and hard whether increasing my debt to then negate my cash flow increase was the right financial decision in this low interest rate environment. Doing a cash-out refinance is definitely something to consider if you have a hefty amount of equity in your property.
HOW TO DECIDE WHETHER TO CASH-OUT REFINANCE
* What are you going to do with the money? If you have no good plans for the money that will return at least the cost of your mortgage, then you probably shouldn’t cash-out. CD and savings rates are still much lower than your mortgage rates, so you will be losing money every month you don’t put it to good use. Nothing is a guaranteed return, so think long and hard before plopping that cash down on something that sounds so good.
* What’s your outlook on the property market? If you think the markets are going to tank 90%, then by all means cash out! You don’t want to see your equity disappear. If you can legally cash out and have free cash in your bank account, then please do so before it disappears. In the event of a market crash, it is then up to you to decide whether you should pay your mortgage or not. You should if you live in a recourse state, and maybe not if you live in a non-recourse state. Just don’t brag about it and try and profiteer if you do welch on your debt!
* How disciplined are you? Some people go crazy irresponsible when they have a sudden influx of cash. If you are making say $100,000 a year with $50,000 in savings, could you handle an extra $200,000 in the bank after a cash-out refinance? Would you not be tempted to go on some fancy vacation or buy a car you’ve always wanted? If so, then you shouldn’t do a cash-out refi since you wouldn’t have spent that money if you didn’t get the injection. I have a weakness for nice vacations and cars, even though I haven’t bought one in 4 years and drive a beater.
* How much money are you making? If you already have a high amount of cash-flow or have a a healthy year-end bonus every year and don’t plan to get fired, then perhaps you really shouldn’t do a cash-out refinance. For example, let’s say you want to cash-out $100,000, but you can save $100,000 every year. If this is the case, why bother?
* Understand the rate differential. My banker said I could do a cash-out refinance if I wanted to, but then said my mortgage would have to be re-underwritten, and the rate would go up. Funny how they didn’t tell me this before my appraisal. I was thinking to myself if I borrow more money, I could get a lower rate! Silly me. It’s quite the opposite. This higher rate was the straw that broke the camels back as he tried a little bait and switch. I’m a rate seeker.
* How desperate are you for cash? Interest rates are incredibly low, making living off dividend or CD interest income incredible hard for retirees. Your house is likely your largest asset, which isn’t doing you much good except for providing you a hopefully rent-free place to live. If you are at the point where you have to sell precious belongings, priceless memorabilia, and liquidating your grandchildren’s education funds, then doing a cash-out refinance is a much better option.
A CASH-OUT IS FINE IF YOU ARE DISCIPLINED
Cash-out refinancing is just accounting. You either have cash in the bank or equity in the house. I would actually much rather have cash in hand to do what I want (invest, spend, remodel, travel) than have it stuck in a house which might burn down. Housing will continue to get better over the next 5-10 years. Just make sure that if you do a cash-out refinance that you spend it wisely, preferably on living a better life and investing for more security.
Strong Recommendation: Some of the lowest mortgage rates I’ve seen are by Quicken Loan given they are an online company with low overhead. I know at least 30 people this year who have refinanced through Quicken Loan and with some incredible rates of below 4% for a 30-year fixed and below 2.875% for a 5/1 ARM. I’ve applied before and got matched 2.625% for my 5/1 jumbo ARM! As a result, I’m not saving close to $4,000 in mortgage interest a year. Thank you QE3 and Ben Bernanke!
Regards,
Sam
Coming down to the South Bay with that cash-out money? Think houses are discounted on Black Friday? New LNKD millionaires need to rent somewhere…
Or go grab today’s house on Burbed… it’s in Pacific Heights and is a steal at $8M. Don’t worry, home prices only go up!
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Financial Samurai Reply:
November 22nd, 2011 at 6:02 pm
I like the fixer! I agree. Home prices, especially for the high end have been amazingly sticky here in SF and are rising again. Come to papa LinkedIn money before the Zynga money comes!
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I’d refinance for lower rates if I can materially lower my monthly payments and still come out ahead even with the fees, and then use the money saved from refinancing to repay the mortgage so I can pay off the home sooner.
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Financial Samurai Reply:
November 22nd, 2011 at 6:00 pm
Refinancing now is a no brainer, but that’s not the topic at hand. A cash out is if you have thoughts on that. Good to hear from you!
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I just did a re-finance. The bank had estimated closing costs and they ended up coming in lower than estimated. They wrote the loan for the original estimate saying that they’d just give me the cash out. I refused and it delayed the closing by a few hours because they had to re-write all the paperwork. It was less than $1,000 but I still felt no reason to take that, especially when I’d made it clear up front that I didn’t want cash.
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Financial Samurai Reply:
November 22nd, 2011 at 5:58 pm
Yeah, $1,000 is not worth it. But what would you do if it was a $100,000?
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Hey Sam, I agree with your point about “where will you put the money to make a greater return” and make up for the risk your are taking to “cash” out.
I think I would’ve done what you did, walk away.
You do sound like the last of the big time spenders on a date…..Those valets must luv to see you coming. vroom vroom!
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Financial Samurai Reply:
November 22nd, 2011 at 9:59 am
When we go on out man date for the SF Giants and Atlanda Braves bet, I hope you will not only pay for the juicy prime rib but also roll up in te Doc mobile and valet!
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Dr Dean Reply:
November 22nd, 2011 at 11:13 am
No doubt, maybe not at Olive Garden, though….
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Financial Samurai Reply:
November 22nd, 2011 at 12:23 pm
We be going to the best steakhouse we can find in whatever city we end up in!
I like the idea of having the optionality of cash, rather than have it tied up in the property market. If the property market is indeed recovering, then it’s better to take OUT the equity in the form of cash, thereby increase your return on cash (less cash) and use the cash for something else.
But, if they are going to charge you a higher interest rate, it becomes tougher. It also sounds like a PITA.
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Financial Samurai Reply:
November 22nd, 2011 at 10:01 am
That definitely makes sense since the money sitting in property is underutilized money. Just take new debt to increase return on equity is easy. Figuring out how to beat the cost of debt hurdle is hard.
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If my rental has high interest rate + equity, then I would definitely do a cash out refinancing. Assuming I can get lower rate. My rate is pretty low though and the equity isn’t that high. :(
I’m also not sure if I can do better than 4% in this market.
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I don’t know if I have enough equity in my rental property yet. But I don’t think I can beat a 4% rate of return anyway.
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Doesn’t make sense to me to borrow money through a 5-year ARM for rental real estate. That implies that you’ll either be selling the property within five years, or have confidence that you can increase rent to keep pace with (potentially) rising rates. That’s a bad deal all the way around.
Plus, the short-end of the yield curve still isn’t all that attractive from a borrowing standpoint. Might as well borrow where the subsidies are–Bengenie is working far more magic on the long-end of the curve than the short-end. I’d borrow all day on the long-end of the curve at less than 5%, but we have very different retirement horizons, so it’s not really applicable.
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Financial Samurai Reply:
November 22nd, 2011 at 5:57 pm
You sure about that? I can borrow Libor + at 1.5% now which I’m tempted to do. Dont think inflation is as fast as my 10% rental increase this year, which is on the low end.
Why would you borrow at the long end and pay 4%? You think rates and inflation are going to jack higher soon?
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JT Reply:
November 22nd, 2011 at 8:18 pm
That LIBOR quote must have a floor in place, because doing the math with the above 3.75% doesn’t make sense?
I’d borrow on the long end because I think it presents more value. Sure, I’d pay a higher rate now, but I’d much prefer to lock it in fixed for 30 years at 4% than pay nearly that much with only 5 years of utility. Rates are certain to go higher; they’re depressed right now because of Europe. If Europe settles, rates rise, especially on the short-end of the curve. Might as well go for the long-end, and let Bengenie subsidize me.
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Financial Samurai Reply:
November 22nd, 2011 at 8:31 pm
JT, the 5 yr rate is based on the long bond yield. The LIBOR + margin is for one month floating. Different rates.
Rates have been going down for 30 years JT. Please look at the historical charts.
Let me know when you jump into the property market.
JT Reply:
November 23rd, 2011 at 8:40 am
So you’re talking about two different credit options between the article and your comments. Okay, then.
I know rates have been falling for 30 years; I just don’t know why you think that trend will continue.
Financial Samurai Reply:
November 23rd, 2011 at 11:06 am
That’s why there’s a market. I’ve been right for the past 10 years borrowing on the short end and I’m confident rates arent going higher for the next 3 years.
Want to make some bets and predictions on the Fed funds or 10 yr yield?
Many years ago, I refinanced specifically to take cash to buy another property. I used my equity to build a larger portfolio. Was it wise? Yes! Should everyone do it? No, because of some of the pitfalls you mentioned. Not everyone is disciplined or has a plan. The key word is plan. I planned my expansion and had the discipline to not only do some of these things, but monitor the progress and results. I set up reserves to take care of surprises and I had a history to reflect on to know my risks. Bottom line it worked for me!
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This is a slightly unrelated question. I assume you are in CA and this is a non-owner occupied rental property, right? Do you have earthquake insurance? If not, are you concerned about having a recourse mortgage as opposed to a non-recourse mortgage? If there’s an earthquake that flattens your building, you’re still on the hook for the mortgage, unlike a homeowner who can just walk away.
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Financial Samurai Reply:
November 22nd, 2011 at 12:53 pm
There’s earthquake insurance. This property has been refinanced multiple times since rates have gone down steadily for 10 years. It was at 5.75% in the beginning!
I don’t care about recourse since it’s way in the money and the cash flow is very strong. I plan to either hold forever or sell at a profit.
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AL Reply:
November 22nd, 2011 at 2:32 pm
How much does earthquake insurance cost? It must eat into your cash flow quite a bit?
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Financial Samurai Reply:
November 22nd, 2011 at 3:26 pm
It’s part of the HOA so it’s shared. You thinking of buying a place but seeing high earthquake insurance?
Definitely calculate all your costa for sure before buying as everything costs money.
Personally, I don’t mind having equity in real estate. And you need to consider how much return you could actually garner on the cash out!!! I also try (although not always successfully) to keep things simple.
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Financial Samurai Reply:
November 22nd, 2011 at 10:59 pm
Yes, the older I get, the more I want to simplify. It’s what makes me not want to expand the real estate portfolio too much, and focus on the simplicity of being online.
How is SF treating you Barb?
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Hilarious intro Sam! I haven’t done one myself but I have heard of them a little. I’d trust myself not to burn through the money shopping but I’m sure I’d be quite tempted to use it for travel and that can add up quick. I don’t think I’d want to do one mainly because the idea of having more outstanding debt just doesn’t feel right and I’m not in a situation where I need a lot of cash right now.
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I cashed out once to purchase rental properties. Best choice I ever made. I like the way you talked about it, to many people only see one side or the other.
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