A cash-out mortgage refinance lets you borrow more than you currently owe and keep the difference as cash. It’s one way to unlock the equity in your house. However, doing a cash-out refinance to buy stocks is not a good idea. You could lose a lot of money in a bear market.
Instead of doing a cash-out refinance, you can take out a Home Equity Line Of Credit (HELOC). However, I don't think a cash-out refinance to buy stocks is not a prudent financial move Especially not with stocks at record-high valuations and such lofty earnings expectations post the worst of the pandemic.
The most you can borrow from your house is usually an 80% loan-to-value (LTV). In other words, if your home is worth $1,000,000, and you have a $500,000 mortgage, the most you can refinance would be $800,000 and receive $300,000 in cash.
Cash-out Refinance To Buy Stocks: Bad Idea
Thanks to the coronavirus, the 10-year bond yield declined to near all-time lows and has stayed relatively low even as the economy recovered. Therefore, the desire to do a cash-out refinance to buy stocks and other things is increasing. I caution you not to do so.
Due to luck, in 2019, we ended up buying a larger house with cash. With a second child on the way, we figured why not buy the house a block away if we could get a good deal. The cash we paid ended up saving us from this hopefully temporary market meltdown.
The question now is whether it would be wise to do a cash-out refinance and pull out lots of equity to invest 100% in the stock market. A lot of people have been asking me this question lately with the S&P 500 near all-time high.
If you are thinking of doing a cash-out refinance to buy stocks, here are some of my pros and cons.
Pros Of A Cash-out Refi To Buy Stocks
1) Lock in massive outperformance.
Let's say the S&P 500 is down 10% for the year and you were to purchase stocks. You would instantly lock in 10% outperformance on your cash-out capital. No matter whether the S&P 500 continues to go down or up, you will always be outperforming.
Although it's better to always make money when it comes to investing, the next best thing is outperforming the index or your peers. If an active fund manager outperforms his benchmark by 10%, he will be in the top 1% of active fund managers. Given his performance, he'd probably get a record bonus, attract a massive amount of assets, and be given many awards for the year.
To gain true wealth, you must outperform the average, otherwise, you'll always be just average.
2) Take advantage of low interest rates.
The Fed cuts interest rates to spur economic activity. The lower interest rates go, the more people and businesses tend to borrow to buy equipment, property, goods, and services. Doing a cash-out refinance to spend is in a way, following the Fed's desires.
If inflation is running at 2% and you can get a mortgage rate at 2.375%, your real interest rate is only 0.375%. The lower the real interest rate hurdle, the higher the chance of earning a greater return.
From a nominal return basis, the 2.375% mortgage interest rate drag on returns is comparable to paying a traditional wealth manager to manage your wealth or investing in a hedge fund which charges 2% of assets and takes 20% of profits.
The thing is, mortgage rates are high now thanks to inflation. As a result, it makes cashing out to buy stocks even more expensive.
3) Diversify net worth.
If you have a large percentage of your net worth in real estate, you may want to do a cash-out refinance to diversify your net worth. At the end of the day, the right net worth allocation by age is the biggest determinant of building wealth.
Note that your real estate exposure will only decrease based on your increased exposure in stocks. Your absolute real estate exposure won't decrease since you haven't sold any properties. You just have more debt.
I've got roughly 30% of my net worth in stocks and 40% of my net worth in real estate. I would like to bring the percentage up to 30% if stocks sell off again. However, doing a cash-out refinance to buy stocks doesn't seem like a good idea.
4) You could get a tax deduction.
The mortgage interest deduction may be available on a cash-out refinance if the money is used to buy, build or substantially improve your home.
In general, homeowners who bought houses after Dec. 15, 2017, can deduct interest on the first $750,000 of the mortgage. Claiming the mortgage interest deduction requires itemizing on your tax return. As always, check with your accountant.
Negatives Of A Cash-out Refinance To Buy Stocks
1) Refinancing takes time and costs money.
It takes between 1 – 4 months to do a cash-out refinance. Depending on your mortgage rate, your fees will either be baked into your cash-out refinance or you will have to pay fees. Closing costs usually cost between 1% – 4% of your mortgage. If you don't have a good one, dealing with a bank can be a PITA.
By the time you've got your cash, the stock market may have moved up to the point where it is no longer attractive to buy. If you don't use the cash, you'll then end up with a cash drag.
Here are all the mortgage refinance fees when doing a no-cost refinance. Refinancing generally costs at least $2,000 and up to $8,000.
2) You could lose money.
As we all know, there are no guarantees when it comes to investing in stocks or any risk assets. Stocks have a fantastic way of quickly losing value, which is why I always encourage folks to practice taking profits to pay for a better life.
I could lock in a 10% outperformance, but if I lose 10% on let's say $1,000,000 from a cash-out refi, I'm not going to be happy. I would have rather kept the $1,000,000 locked in the house and have it outperform by 20% without doing anything. Even if I were to make 10% with a stock rebound, making $100,000 may not bring me much joy.
You do not want to lose money on margin. This is how people lose everything.
3) Increase foreclosure risk.
If you end up losing a ton of money in the stock market after your cash-out refinance, you might reach a point where you are no longer able to pay your mortgage.
Because your home is the collateral for any kind of mortgage, you risk losing it if you can’t make the payments.
4) You complicate your finances and your life.
One of the reasons why I've never regretted paying off a couple of my mortgages is because each time I paid one off, I was able to simplify my finances. It feels phenomenal to pay off debt. To not have to manage another account is like icing on the cake.
The older and wealthier I get, the more I want to simplify my finances. My goal is to pay off all mortgages by 2027 when my latest 7/1 ARM refinance resets. I'm no longer in the business of trying to take as much leverage as possible to make money. Instead, I'm in the capital preservation stage so I can live as financially stress-free as possible.
Don't Do A Cash-out Refinance To Buy Stocks
Conducting a cash-out refinance to buy stocks is a suboptimal financial move. Yes, stocks tend to provide an 8% – 10% annual return over the long run, but you could face a negative sequence of returns after your purchase.
If you absolutely want to use some of your home equity to buy stocks, then I would wait until there is at least a 30% correction in the S&P 500.
I use 30% as a benchmark because the average bear market since World War II has seen a 32% decline. Therefore, if you buy stocks with your home equity after a 30% decline and can hold on for at least a year, you will probably make money based on history.
We saw a 32% decline in March 2020. And it could happen again, especially after the S&P 500 has roared back so strongly.
Just make sure that if you plan to do a cash-out refinance to buy stocks that you also have enough liquidity to survive. When stocks are down 30% or more, the economy is down in the dumps. During this time, you might lose your job and your other investments may also lose lots of value.
Cash-out Refinance to Pay Down Debt Instead
The wisest thing you can do with your cash-out refinance is to pay off higher interest rate debt, if any. Given the average credit card interest rate is still a whopping 17%, your guaranteed return is probably greater than the average return in the stock market.
I plan to keep life simple and live in our new home without carrying a mortgage. It feels good not having to make any mortgage payments. It also feels good to provide an appropriate amount of shelter for my family. I don't really care about my house's value because I plan to own it for decades.
As for stocks, I've already used up a majority of my excess cash to buy the ~12% correction. if the S&P 500 corrects by 20% (<2,700), I will start selling my muni bond funds and buy stocks. It's a decent trade since the muni bond funds will have performed quite nicely in such a scenario.
If the S&P 500 corrects by 30%, I may consider doing a cash-out refinance because that means mortgage rates have gone even lower! Whatever happens, I'll always be investing some of my monthly cash flow into the market.
Bottom line: Don't conduct a cash-out refinance to buy stocks. Do always have enough cash on hand to take advantage of random investment opportunities. Do refinance your mortgage when Treasury yields fall to all-time lows. And hold onto your property for longer if you've locked in a great mortgage rate.
Cash-out Refinance To Buy Real Estate
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income.
Real estate is also less risky than stocks. Therefore, you may want to do do a cash-out refinance to buy more real estate instead. This is what many people have done to build wealth over time. You just have to do so in a prudent manner.
Instead of buying another property with a mortgage, consider buying real estate more surgically through real estate crowdfunding instead.
Take a look at my two favorite real estate crowdfunding platforms.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the easiest way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
I've invested $954,000 in real estate crowdfunding across 18 different properties to diversify and earn income passively.
Invest In Private Growth Companies
Finally, consider diversifying into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.
Check out the Innovation Fund, which invests in the following five sectors:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum.
If you want to do a cash-out refinance and buy stocks, make sure you can withstand a 1-2 year bear market. If you have no problems losing ~30% of your portfolio's value while paying more mortgage interest, then maybe you'll be OK. But I think the better strategy is to keep paying down debt and invest only with the cash you have.