Mortgages and Refinancing: A Tale of the DC Real Estate Market

You often hear a home referred to as a family’s “biggest investment.” If we are brutally honest, however, a home is really a family’s largest debt obligation. This is especially true today as many people refinanced and consolidated their multiple debt obligations into their homes during the real estate boom. We are all painfully aware of the consequences of relying too heavily on equity from your home to finance your lifestyle. Today’s post is about understanding mortgage financing and how to find the information you need to evaluate mortgage decisions.

First, a brief primer on the real estate boom here in the nation’s capital. In 2001, I assisted with a real estate purchase for a family member. At the time, the real estate agent warned that we were likely buying “at the top of the market” and that she could not guarantee any investment return. Prices in 2001 were slightly inflated due to the dot com boom, the wealth generated through the stock market and the demand for workers and housing in the DC area. After 2001, however, the dot com bubble burst, wiping out many stock portfolios and revealing widespread fraud at many start-ups.

Two years later, it seemed like everyone was buying a home. People were even taking out second mortgages and interest-only loans to purchase investment real estate and second homes. Real estate investing appealed to people who felt burned by the dot com stock market crash. Stocks were complicated and required inside information to evaluate properly. Real estate seemed simple in comparison. Some people even felt that homes and land were appreciating so fast that if they did not invest right now they would “never” be able to purchase a home.

After saving for a downpayment for years, in 2003, my husband and I purchased our home. We knew that home prices were inflated and beyond the reach of most families. It took us seven months to select a home that we knew we could stay in for a long time if the market turned sour and we could not sell. Still, it felt like a pretty good deal because mortgage rates were relatively low at the time (less than 6%).

In 2005 the DC real estate market peaked. Soon after, prices began to fall and now in 2010, our home appraises for about 5% less than we paid for it initially. We know many families who feel “stuck” in their homes because values have fallen so sharply. Mortgage rates are even lower than when we purchased, averaging less than 5% for many 30 year mortgages.

The painful lesson of the collapse of the real estate market is that real estate investing and mortgage financing is complicated–as complicated as stock picking–and, due to the large dollar amounts involved, can be even more devastating to a family’s finances if done quickly, without understanding the financial implications.

For today’s post, I wanted to illustrate the complexities of mortgage financing by going through a refinancing example for the Medians.

Assume, for a moment that the Medians are chatting with a neighbor and complaining about the budget cuts they are going to have to make over the next 3 years to get out of debt. The neighbor tells the Medians that she was able to avoid such budgeting problems by simply refinancing all of her outstanding debt into a new mortgage loan. She paid off all of her debts and now just has one mortgage payment to pay, noting that the mortgage interest is also tax deductible. She gives the Medians the name of her broker.

The broker tells the Medians that for about $1,200 in closing costs, she can refinance their $19,300 in loans (car loan, student loan and credit card debt) into a new mortgage. Their mortgage would increase from $150,000 currently to $169,300 and the interest rate would be fixed at 5.5% which is lower than any of the non-mortgage loans. So, rather than paying their current mortgage plus $475 in other debt payments, their new mortgage payment would be $961.27, freeing up about $365 “extra” each month with no required budget tightening.

*For purposes of this example, you have to assume we are still in the mortgage boom and that this kind of “cash out refinancing” is still available. In 2010, cash out refinancing is pretty much off the table for most people, either because their home value has fallen and there is no equity to tap or because lending standards have tightened with many lenders capping borrowing at 70-80% of a home’s value. In my limited research, I could not find a single lender that would be able to refinance all of the Median’s $19,300 in loans into a new $169,300 mortgage.

Is the refinancing a good idea? We will explore that below. First, a couple of notes.

Whenever you hear about any sort of scheme to convert high interest debt to low interest debt, you are usually converting unsecured debt to secured debt. Secured debt means that if you don’t pay, there is some other way for the lender to get their money back. Mortgages are secured debt because if you don’t pay, the lender can foreclose on your house and sell it to someone else. Credit cards are unsecured debt because if you don’t pay and you truly don’t have any income, the credit card issuer can’t really do anything about it except write your debt off as a loss.

Many financial advisers are wary about advising people with low incomes to convert to secured debt because a small financial crisis can have an enormous impact. It is one thing to have a black mark on your credit rating because you are not paying your credit card and another to be out on the street because your home was foreclosed. Lately, another common question is about using student loans to pay off credit card debt. This is also an unsecured to secured conversion question. Click here to read Steve Bucci’s Debt Adviser response to this question.

The other issue that comes up with debt conversions is the psychological impact of debt consolidation. For most people, balling up all your debt into one payment and freeing up cash makes it really easy to indulge in other purchases. Why not add a granite countertop, a pool, a new deck, or even a new car? After all, now you can finally “afford” it due to the miracle of refinancing. Right? If you can avoid scrimping and saving and living frugally, why wouldn‘t you? Let’s find out.

Below are two scenarios for the Medians. We will call the first scenario, the “Frugal” scenario, meaning that the Medians don’t refinance. They are going to live frugally for 3 years to pay off their credit card, car loan and student loan as well as amass $5,000 in emergency savings. After that is accomplished and they are debt free, they will stop living frugally but continue to put $100 per month in an emergency fund and save the money that used to be going to debt payments ($475 per month) in a savings account.

The second scenario, the “Refi” scenario means that the Medians go ahead with the refinancing. They free up about $365 per month immediately. They don’t decide to live frugally but they do agree to put $100 a month in an emergency savings account and will put all of the $365 that would have gone toward debt payments in a savings account. Although unrealistic, for purposes of simplicity, we will assume that the Medians somehow come up with the $1,200 in refinancing costs through a one-time gift from a family member and there are essentially no refinancing costs.

How do you do the math to figure this out? It takes some time but it does not require a college degree in mathematics. You need to add and subtract some budget numbers and use a mortgage amortization schedule calculator, like this one from bankrate.com.

Monthly Cash Flow — First Five Years

Annual Cash Flow — First Five Years

Total Cash Flow — First Five Years

On the upside, the Refi seems to make a lot of sense after 5 years. You don’t have to go through three painful years of saving to pay off the credit card, student loan and auto loan and you get an instant boost of $365/month! After 5 years, if you saved every penny of the $365, you would have $27,900, almost $11,000 more than the Frugal repayment plan (again, assuming no refinancing charges).

After you look at this, you might think, “Why doesn’t everyone refinance?” What could possibly be the downside?

Now, assume after 5 years, Mr. Median has received a new job offer in another state and the Medians have to sell their home. Their timing is horrible and the value of their house has fallen 40% from its high of $200,000 to just $120,000 today.

For the “Frugal” repayer, the loss on their home is small enough that they might be able to charge it to a credit card if they had to. Failing that, they should have enough saved up after about 4 months to get themselves out of the hole. For the “Refi” repayer, the loss on the home is substantial and will require over 2 years worth of saving just to pay back the loss. The “Refi” repayer may have to make the sacrifice many families are making now and have Mr. Median start his new job in another state and rent an apartment while the family stays behind trying to get rid of the house obligation.

Even if there is no need to sell the home and both the “Frugal” and the “Refi” repayers stay in their homes for the full 30-year duration of their mortgages, we see that eventually the “Refi” catches up to you. After 30 years, the “Refi” repayer pays over $18,000 more in interest than the “Frugal” repayer, even though the “Frugal” payer paid much higher interest rates in the first 3 years for the non-mortgage debt.

What about the “tax savings” of the Refi? This one is really hard to model since taxes depend on so many variables. There are situations like the AMT (Alternative Minimum Tax) where you might not get a tax advantage at all. If we roughly assume that the Medians get a 25% boost due to the tax deductibility of their mortgage payments, it might lower the 30-year difference to $14,500. And you have to wonder if the tax savings are really just off-setting the refinancing costs.

The black and white message on debt consolidation through mortgage refinancing then is that it might be convenient and it might free up needed cash flow immediately but in many (and maybe most) cases, it does not save you money over the Frugal method.

Are there reasons to refinance? Absolutely. Many people are refinancing now to take advantage of record low interest rates. Refinancing, however, tends to work best for people with a lot of money. If the Medians had $10,000 in cash, for example, they could buy down some points and consolidate their debt in a 4.5% mortgage or maybe they could consider getting a 15-year or a 10-year mortgage and pay their home off faster. You could save a lot of money that way. You could also just refinance the existing mortgage and pay off the other debt the Frugal way.

Many people find these debt refinancing calculations incomprehensible but I hope you see that anyone with a little time and effort can figure them out for themselves. And if you can’t figure it out, then I beg you to consult with a professional financial advisor to do the calculations for you before you plunge into something you don’t understand.

NPR did a story this week profiling one California neighborhood that illustrates perfectly the impacts of certain financial choices with regard to mortgage refinancing. Click to listen here. As you can see, the temptation to spend in the Refi method is very hard to overcome.

My head is spinning a bit from all these numbers and I hope that you were able to follow my discussion. Please share in the comments your thoughts on mortgage refinancing. Which choice would you advise the Medians to take?