Financial Contrarian #7: Debt Quick Fixes Part II

Thinking about a huge pile of debt can be pretty scary. When we humans get scared, we often do irrational things. When we’re afraid, we dream of being saved from that which is scaring us. We also become susceptible to those who would take advantage of our fear, and vulnerable to debt quick fixes.

When we’re afraid, as in the case of a mountain of debt, quick fixes are appealing. The idea that the monster can be made to go away with one simple solution sounds very good. Why not end the stress and fear immediately? Why not do a debt quick fix?

The problem is that, in most cases, it is only an illusion that the problem is being solved, that the monster is going away. In Financial Contrarian #5: Debt Predators and Quick Fixes we explored a few of the vultures and bad ideas you can fall prey to. 

In this post, we’ll discuss two more debt quick fixes, both related to homeowners with built-up equity—cash-out refinancing and reverse mortgages. Most often, despite the illusion of being solutions, these ‘quick fixes’ can make the situation much worse. Let’s explore how.

Cash-Out Refinancing

Cash-out refinancing is when you replace your existing home mortgage with a new one. At the same time, you extract your equity in the form of a loan. If you’re doing this to pay down debt, it means you aren’t accomplishing anything. You’re just moving the debt around, in fact in most cases, taking unsecured debt and changing it to secured debt—putting your home on the line.

For example, if your home is worth $200,000 and your mortgage balance is $110,000, you have $90,000 in equity in your home. You could theoretically do a cash-out refinance for $200,000 and receive a check for $90,000! (However, cash-outs are typically limited to 80-90% of equity, not 100% as in our simple example). Such a shame, as your home was almost half-way paid off!

Below are some reasons that this is a bad idea (other than in dire circumstances such as an impending foreclosure or unavoidable bankruptcy).

1. Tax implications: The home mortgage deduction is being phased out. Refinances used for non-home improvements are not tax-deductible (the IRS got wise to this years ago). This costs you at tax-time, as opposed to your current mortgage, where the interest (up to declining limits) is still somewhat deductible.
2. Fees: You’re going to pay quite a bit for appraisal fees, application fees, title search, and loan origination fees. It’s a whole new mortgage, with all of that yukky paperwork, stress, and expense. Closing costs, ugh!
3. Equity: You’ll be taking a loan on your home equity and paying interest on it! This is what broke people do, not what wealthy people do. This is similar to 401k loans where you pay interest on your own money and pay them back with taxed money, then get taxed again when you do withdrawals in retirement – double taxation. When you cash-out refi, that beautiful, treasured equity in your home is now gone—poof! You’ve turned it into more debt, the last thing you need.
4. Interest: A refinance restarts the loan amortization. You go back to square one, where most of your payment is interest, not principal. You had come so far! Check your past amortization schedule and tell me this doesn’t feel bad. It’s going backward, again. As we discussed above, the interest deduction is also being phased out, so it’s another loss. Because this loan is larger than your current remaining mortgage balance, you may have to accept a higher interest rate. The same goes if your credit score is worse than it was when you took the original loan.
5. Private Mortgage Insurance: If you’ve paid off more than 20% of your home’s value, and as such have less than 80% loan to value, you should no longer have that nasty Private Mortgage Insurance (PMI) in your mortgage payment. It’s insurance for the bank, not for you. Or, you might be close to 80% LTV, meaning a lower payment! The refi puts you backward again and likely paying PMI for a long time.
6. Foreclosure Risk: If the economy goes bad as it did in 2008, and people who never dreamed they’d lose their jobs lose them, and home values plummet, folks would again be far underwater in home value/loans and forced to just walk away. The cash-out refinance exacerbates that risk. None of those folks back in 2008 thought it would be them. We’ve been in a long bull run, and the coming correction is expected to be severe. The US government and most corporations are way, way over-leveraged in debt—a bad place to be in a downturn. Don’t join that club! You’re moving unsecured debt (which, in a crisis, you could just ignore) to secured debt, where you could lose your home to foreclosure.

Cash-out refinancing is just another ‘quick fix’ that sounds good on the surface (like the 401k loans that are bad for so many reasons—you’ve missed out on significant growth, 20+% this year alone…). It’s a trap that just re-shuffles debt, feels good for a while, but leads to more trouble down the road.

As an alternative, how about doing a normal refinance on your mortgage to take advantage of a lower interest rate, get a shorter (not longer!) payoff date, and get rid of any PMI. You can possibly go into retirement without a mortgage, and then take any savings in the payment amount and put it toward your debt. Win-win!

Be disciplined and follow a plan to be debt-free (other than your mortgage) in just a couple of years. It’s just a couple of years effort, to spend the rest of your life without debt and living stress-free in early retirement. Working for it, rather than using ‘quick-fixes’, reinforces good behavior and prevents bad habits from coming back. Most folks that use gimmicks like cash-out refi end up going back to the same ways that got them into the situation in the first place, once they get that check in their hands.

Reverse Mortgage

It’s really upsetting to see actors who played trusted figures on television shows and movies now hawking products that could be so disastrous for seniors. Commercials for reverse mortgages are ubiquitous. Reverse mortgages are only for those age 62 or older.

In a reverse mortgage, you get cash based on the value of your home, and you don’t have to pay it back immediately. Any time you hear that you don’t have to pay something back immediately, sirens should go off in your head, along with a flashing sign that says “interest is accruing, the debt is growing!”

You can get that cash in a lump sum, as monthly payments, in a line of credit, or some combination of those choices. You can only do this once.

The reverse mortgage must typically be paid when you move out of the home, sell the home, or the last person on the deed passes away. You may not plan to ever move, but often life happens. The home may become a problem due to illness or injury as we get older, you may desire to be closer to your grandkids, or you may later get the bug for warmer weather. Having that reverse mortgage looming would be an impediment to your plans.

Here are a few other reasons a reverse mortgage can be a bad idea.

1. Equity: As in the cash-out refinance discussed above, you are essentially borrowing on the equity of your home. So it’s bad for many of the same reasons listed for that option.
2. Fees: Any mortgage involves closing costs, and this is no exception. See the fees listed in cash-out refinancing above.
3. Government Benefits: A reverse mortgage can affect your eligibility for things like Social Security Supplemental Security Income (SSI) and Medicaid.
4. Shady Operators: This space is filled with predators who are anxious to take advantage of senior citizens. In recent years, the rules were tightened up to make this less of a scam, but nonetheless, it remains a very poor choice in almost all circumstances.
5. Legacy: If you want to leave your home to your heirs, this complicates the picture. They would have to pay off the reverse mortgage. Borrowing on your equity also leaves less for them to inherit.

If you feel you must go this route, contact us at Money Coach Group for a review of your complete financial picture and analysis for better alternatives. Ensure that your loan is insured by the Federal Housing Administration under the Home Equity Conversion Mortgage (HECM) program.

Summary

Resist the urge to fall into these traps. If something sounds too good to be true, it probably is. Apply your rational mind every time you feel attracted to some impulsive decision. Go through the math, think things through, talk them over with an expert before you make any big decisions around your finances.

If you need help, reach out to us at Money Coach Group. We have new, inexpensive plans that don’t lock you into anything. Read our client testimonials. Maybe we’re that savior you’ve been dreaming about. We’d love to help you down the path to BE. DEBT. FREE (and on the path to building wealth)!