✪ The $70,000 refinance mistake

The $70,000 refinance mistake

I was recently reviewing the documents that a new client “Ralph and Alice”* provided, and something seemed off.

When we create a personal financial plan, we request several documents. Tax return, investment statements, insurance coverage pages, and estate documents to name a few.

I also request debt related info such as mortgage statements.

On our initial call, they mentioned they had lived in their home for over 25 years and weren’t planning on moving any time soon.

The mortgage statement however said there were 29 years left on the mortgage and the rate was just over 7%.

On our next call, I learned they refinanced their mortgage last year and did what is called a “cash out refinance.”

Here is an example of how this works.

Charlie* has a mortgage balance of $200,000 but his house is worth $800,000. He has $600,000 of equity. Lenders will let you take cash out of your house when you refinance to use for whatever you like. This could be home improvements, or it could even be for travel.

Usually, one refinances to obtain a lower interest rate if rates have dropped from when they first obtained the mortgage. This can make sense as it can lower your monthly payments.

Now, in Ralph and Alice’s case, they actually went from a loan with 5 years left and an interest rate of 4.75% to a new 30-year mortgage at 7.125%.

When we talked further, they explained that they wanted to pay off some credit card debt and buy a new car, so they refinanced and took out $70,000. As Ralph put it, “It was like getting free money”.

Their mortgage payment increased but Ralph did the math, and the new monthly mortgage payment was less than what they were paying on the credit cards plus what a new car payment would be.

This may be so, but I think Ralph might have missed something. True, their current overall monthly outflows might be less, however, the following is also true:

They had about 5 years left on their mortgage and now they have 29 years left
They took short term debt i.e. credit cards and an auto loan and turned that into 30-year debt
They have increased the amount of interest they will pay over the next 29 years to an astronomical amount. (MUCH more than the $70,000 they took out in the refinance)
Since they only had about 5 years left on their mortgage, it was mostly principal that was being paid back

5. Lastly, the $70,000 was not "free money". It needs to be paid off and if you factor in the interest, it was really far off from free.

What could they have done instead?

Leave the mortgage as it was
Pay the credits off more aggressively
Look for a more affordable car with a possible low interest rate
Obtain a Home Equity Line of Credit (HELOC) to pay off higher interest debt as long as they set up a plan to pay the HELOC off in 5 years. For example….

They obtain a HELOC in the amount of $50,000 at 8% interest and pay $1,000 a month toward it. In about 5 years, the HELOC would be paid off and their mortgage would have been gone. And this date coincided nicely with their desired retirement age of 65.

Before taking on new debt, refinancing old debt, or anything else that is a major financial decision, it is always best to speak with a Certified Financial Planner™ practitioner.

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*Names have been changed

All the best.

Rick Fingerman, CFP®, CDFA™, CCPS®

617-630-4978

Rick@PlanWithFPS.com

Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, medical, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS