[00:00:00] Speaker A: In this episode, we cover the second of two ways that you can access the equity in your home without selling the property. A, uh, cash out refinance. Let's get started.
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I'm Brenton Harrison, and this is the New Money New Problems podcast.
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[00:00:48] Speaker A: My name is Brenton Harrison of New Money new problems and your host for the new Money New Problems podcast. If you've been following with us the last few weeks, we have been alternating between episodes on the structure of financial services and then also episodes on homeownership and accessing the equity in your property. Two weeks back, we did an episode on home equity lines of credit. But since I believe in learning through repetition and building on what you've learned in the past, it's, uh, always good to do a refresher. So, let's do a quick recap of a home equity line of credit. If you see on screen, we're looking at a home that's worth $400,000. And depending on the lender, depending on the time and the economy, most lenders are going to pick a certain percentage of your home's value. So let's assume that we have a $400,000 home, and we're taking 80% of our home's value. That's $320,000. And maybe we have a mortgage on that property of $280,000. We're going to look at the difference between the two, $320,000 minus $280,000. And that $40,000 difference is going to be available to us on a home equity line of credit. Now, a home equity line of credit, or HELOC, is a second debt that is tied to your property, but it exists separate and apart from your mortgage. So sometimes when people are talking about a HELOC, they refer to it as a second mortgage. And that's kind of accurate, because not only is it not your original mortgage, but in terms of priority, if something were to happen and that property were to be seized, the lender who's offering you the home equity line of credit is actually in second position behind the lender who has your current mortgage. Now, there's pros and cons to having a heloc that's separate from your mortgage. Uh, one of them being if you have a low interest rate mortgage, like people who got their homes or refinanced their homes in the pandemic, you don't have to worry about refinancing at a higher interest rate. It gives you some flexibility in terms of how you repay it, because HELOC payments are interest only. But one of the downsides to a home equity line of credit is because it's not tied to that property where that mortgage payment is fixed over the course of 15, 2030 years. With the HELOC, you have to find some type of repayment mechanism to either pay it off in full by the end of that period or during that period, or you can roll what you have left into a new mortgage, which would force you to refinance it at, uh, current interest rates anyways. Or in the latter scenario, you would also have the option of extending that home equity line of credit for another five or ten years pending your lender, allowing you to do so. And I can say through experience that when dealing with home equity lines of credit, I've seen many scenarios where people have used them for good things. I've seen plenty of scenarios where people use it to put pools in place or renovate homes. And I mentioned in that episode that, I'm not really a fan of that, but I have seen plenty of instances where people use a home equity line of credit to do something that actually makes or saves them money. The problem, however, is that on the backside of that, when it comes time to repaying what's on the home equity line of credit, in many scenarios, even though the initial funds were used for good reasons, there is not that repayment plan. And you end up having somebody who has had the same balance or pretty much the same balance on their heLOC for the entirety of the five or ten year period. And then when you get close to the end of its expiration, all of a sudden we're trying to figure out what to do. So in this episode, I wanted to talk about the second way that you can access the equity in your home without having to sell it, and that is through doing what's called a cash out refinance. So let's switch up the options and the things that we see on screen in terms of our example. And again, if you're not following along with us on video, we will put this screenshot in the show notes as well. But what you see on screen is a comparison of a HELOC to a cash out refinance. We just went through the scenario of the HELOC on the left. On the right. Let's talk about how the cash out refinance differs. Now, one of the things that you see with the cash out refinance is the formula for figuring out how much equity that you have available through this is similar to what you find with a, uh, HELOC. You take a certain percentage of your home's loan to value. You subtract the balance of your mortgage, and what's left over is the available equity that you can use through a cash out refinance. Now, in this example that you see on screen, in both the HELOC and the cash out refinance example, we've used 80% of the loan to value. I don't want to confuse you. There's no reason to get into different percentages in terms of showing you numbers on screen. But understand that when it comes to the percentage of your home's value that you have access to, you will often find that with the home equity line of credit, you have more than you do when it comes to a cash out refinance. I mentioned in the HELOC episode that in certain periods of the economy, certain lenders will go almost up to 90% of your home's value when they're calculating how much equity you have access to through a HELOC. With a cash out refinance, you're almost always going to see that percentage stop at 80%. So if apples are being compared to apples in most periods, you're going to have access to less of your home's equity in a cash out refinance than you would with the home equity line of credit. But for our, uh, example, for conversation's sake, let's take that same $400,000 home, the same mortgage balance of $280,000. We're going to take 80% of that home's value, 320,000, going to subtract the $280,000 mortgage, and we have access to $40,000 of available equity. Now, here's where the difference comes into play between the two with the HELOC. When you sign up for a HELOC, you are not necessarily borrowing the $40,000. You're just signing a document that opens a line of credit where you have access to $40,000. If you don't borrow the money, you don't owe anything. So you have people who will open up home equity line of credits. I often recommend it for clients of mine who have homes with significant equity, and they're opening it just in case they need it, not because they need it. So it will sit dormant until that opportunity or that need arises. With a cash out refinance, it works very differently because when you choose how much equity you're going to access through this cash out refinance, you are going to come to closing and they are going to give you a check for that amount. So instead of you signing a document and creating a $40,000 line of credit, in our example, you're going to come to closing and get a check from your lender for $40,000. This means that you have actually borrowed the money. You don't have access to it. You formally borrowed it. And instead of you having a separate line of credit that exists apart from your original loan, that $40,000 in our example that you borrowed actually goes on top of the balance that you owed on the old mortgage, and it creates a new mortgage at the new and higher balance. So in our example, you owed 280, you borrowed 40, you have a new mortgage balance at $320,000, meaning that this wipes away and actually changes the underlying structure of your current mortgage. So that's how it works in terms of the functionality of a cash out refinance as compared to a HELOC. And after the break, we'll tell you some of the reasons why you might choose to use this form of accessing equity as compared to taking out a HELOC.
[00:07:46] Speaker C: This is the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen. We'll be right back.
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[00:08:54] Speaker A: When you talk about the reasons that you would use a cash out refinance as compared to a home equity line of credit, I'm going to give you four of those reasons. A lot of them depend on the dependability of the payment. We've mentioned that with a home equity line of credit, you have the ability to make interest only payments, but you also have to consider the fact that those interest rates that you're paying are variable. So during periods where the interest rates are going up, you're going to see your HELOC payments go up. And it becomes not only a budgeting exercise where you're trying to figure out, with these changing amounts, how much it's going to take you to pay off these balances in a certain period of time. It also becomes a matter of discipline, because, again, because you're only required to make the interest only payments. Most people, when they have periods where they have other financial priorities and they're not required to make extra principal payments on the HELOC, they choose not to. With the cash out refinance. However, because you're lumping that amount that you borrowed into the mortgage, you have to make your mortgage payment every month. So it's forcing you to repay the principal and the interest. It's not something that you have to have the discipline to do, and that can have its benefits. But when it comes to some of the other reasons beyond flexibility, let's go through four different scenarios to talk about why it might be beneficial to do so. The first scenario is that you have a current mortgage at a high interest rate, and, uh, you're able to take out the equity through, uh, a refinance process while still lowering the interest rate on your mortgage. You saw this all the time when we were in 2000 and 22,021 and 2022, and interest rates were going lower and lower and lower. And you had these people who had mortgages at five and 6% who are now able to refinance and go down to 3% or 2.5% or 2%. And in that process, not only were they able to significantly lower their interest rate and their payment, they were able to, in some cases, take some of the equity out of their home and still keep their payment the same or even have a lower payment. So you might have had a $300,000 mortgage at 6%. You refinance that mortgage and take out $50,000 of equity down to 3%. And even though your new balance has gone from 300 to 350, that interest rate makes such a difference that your payment either stayed the same or even went down. And when you look at not just your monthly payment, there was a benefit there, but the total cost over the course of that 30 year period still compared favorably to what you had on the original loan. And if that's the case, then it can be a wonderful opportunity to strip some of the equity out of your property. Now, it's harder to do in periods like this, where, since that period of time, interest rates have gone up, and maybe there's not as much of a spread, or maybe there's no opportunity to get a lower interest rate as compared to what you currently have on your mortgage. But if interest rates go down again, and they will eventually go down again and you have untapped equity in your property, there is a scenario, or, uh, there are scenarios where you can refinance at that lower rate, take the equity out, and not adversely impact the total cost of repayment over the course of 20 or 30 years. The second scenario where it can be beneficial to access that equity through a cash out refinance, is if you're using it to pay off problematic debts. And here's where we talk about the concept that I share often on this podcast, that concept being that nothing in your financial life happens in a vacuum. Everything that you do in one area of your finances impacts the other area of your finances. And I'll tell you why I bring that up. It's because when you talk to financial advisors, uh, about the benefits or the cons of doing a cash out refinance, they will say, oh, well, you shouldn't do it, because you're adding that balance onto something that's being repaid over the course of 20 or 15 or 30 years. And even though it might be beneficial in terms of your monthly payment, spreading out the repayment at interest over such a long period means that you'll pay so much more for it over time as compared to just paying it off where it is now. If things did exist in a vacuum, then they would be absolutely right. If that were the only consideration that you had to keep in mind, then you would rarely, if ever, do a cash out refinance. Matter of fact, if you're looking along on screen, we have a scenario where we have a person who's taken out a $50,000 loan for 30 years at 7% interest, and you can see that that additional $50,000 of equity that they access in their home cost them $333 a month to repay. But over the course of 30 years, they're going to pay $69,000 in interest on top of the 50,000 that they borrowed. So that $50,000, by the time they reached the end of their repayment period, actually cost them $119,000. So, again, if that were the only consideration this would be something that they would never do. But the fact of the matter is, it's not the only consideration. You have to keep in mind the fact that these people might be using this equity to pay off credit card debt. They may be using it to pay off a student loan that either has an astronomically high payment or an astronomically high interest rate or some combination of the two. And while it may cost them more over the long term to pay it off over 30 years as compared to the five or ten that may be left on those debts, the fact of the matter is the payments that are associated with those debts may be so high that it keeps them from doing other things that they need to do, like from base level, doing things like getting insurance or establishing an estate plan, or establishing savings or contributing to their retirement plan. So while, yes, in a vacuum, you wouldn't want to pay $120,000 to borrow 50 in the short term, if you're looking and you're saying by taking it and repositioning it in this way, it opens up my ability to access and contribute to all those other things, putting all of those factors together can still have it make sense. So the second reason that you would use that cash out refinance is if you're using it to position or pay off other debts in a way that increases the flexibility that you have elsewhere in your finances. The third scenario where it could make sense to do a cash out refinance is if somebody else is paying back what you owed for you. So we have people who have used the equity from their home to cash it out and then buy an investment property and rent it out to a long term tenant, or maybe they're doing a VRBO or an Airbnb, we have people who have even used the equity in their home to use as a down payment on their new and better home, and then they rent out the home from which they took the equity. And if you have a tenant in place or some type of arrangement where you're borrowing the money, and yes, it costs you more over the course of time, but someone else is repaying that debt for you, then it can absolutely make sense to use a cash out refinance and not have to worry about the fluctuating interest rate or the fluctuating payment that comes with the HELOC, or just wondering if you're going to have a plan to repay the principal, you can take it out. And even in the scenario where it increases the interest rate on your property, as long as you have a tenant that's covering the mortgage, the upkeep of the home, it doesn't really matter because the home is cash flowing. You're not having to pay it down at that higher interest rate, and you're still getting the benefit of using that equity to do other things in your financial life. And the last scenario where it can make sense is if you're using the equity in that property to make money elsewhere, and the opportunity cost of not using that equity is too high. An example that you see frequently with this is when people use the equity in their home to do things like start a business. An investment property would qualify for that, too. But let's say that you're trying to start a business. You're not yet in a position where you can get a small business loan. You want to have something that's somewhat of a backing in case you just are not going gangbusters from the start, but you believe and have a plan in place so that over the course of time, that business is going to be something where the profits that you earn from it far exceed the extra interest that you're going to pay from the equity you took from the property. Well, in that scenario, if taking that equity or not taking it is the difference between you starting or not starting that business, starting or not starting that venture, then it's something that you should absolutely consider. Because while we did cover the fact that for most people, there is no tax benefit for owning a home based on the way that they file their taxes, the ability to have a pseudo small business loan that you can spread out over 30 years, and all you have to do to keep up with the terms is just make the mortgage payment that you are already going to make because it's your property, those terms can be really appealing as compared to a small business loan that you might have to pay back in two or five or seven years. So for all these reasons, I wanted to make you not just aware of the differences between a cash out refinance and a home equity line of credit, but I also wanted to give you some concrete examples of when you might choose between the two, or if you might choose either of the two based on your circumstance. Next week, we're going back to our series on financial advisors and the structure of their services. Our services.
[00:17:33] Speaker B: I hope to see you there.
[00:17:34] Speaker A: I hope you're benefiting from both series, and I will see you in seven days.
[00:17:41] Speaker B: From new money new problems this was the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities.
[00:17:51] Speaker A: And obstacles they've never seen.
