There are some things that you just donít do because they donít make sense. You donít go to the bank to buy milk. You donít buy a Rolls Royce because itís a great deal, no matter how much you want it. There are other things that donít make sense but are harder to see. It doesnít make sense to pay ATM fees, but at only a dollar or so, it doesnít seem like such a big deal.
Today, with the value of real estate continuing to rise itís very tempting for those who own a home to treat it like a bank, drawing money out either through re-financing or home equity loans. Itís tempting but that is not what these tools were designed for.
Just like a hammer is meant to drive nails, financial tools have set uses, thatís why you donít take out a mortgage to buy a car, you get a car loan (or believe it or not, you could also pay cash).
Because there is so much money ďtied upĒ in their homes and interest rates are low and loans are easy to get, people are doing stupid things. In some cases these people are just making simple but wrong assumptions. When you re-finance your mortgage down to a rate of 5.75% to pay off credit cards at 12.99% that seems like a good idea because the interest rate is so much lower but itís not.
People have been able to do things like this and still reduce their payments so they think itís a win-win situation, they pay less for their mortgage each month and get their credit cards paid off, or buy a new car, or maybe even a second home. But itís not enough to reduce your mortgage payment if youíre just increasing your overall expenses by treating yourself to some expensive toy.
The mortgage example above will lead to extra interest payments of $33,026 for the mortgage when the interest would have been $18,822 for the credit cards. Because youíre spreading those payments out over 30 years, however, the payment is much smaller but look how much it cost you. Now if you donít have any discipline and run up those cards again then youíre in a much bigger mess that you might not be able to finance your way out of.
Itís human nature to want to get the most we can out of what we have. And as long as youíre aware of the dangers this can be done successfully. But if you let greed be your guide then you have no one to blame but yourself. A recent article on the Money.com website makes this very point saying:
ďBut what if you are simply siphoning off your home's equity in order to live beyond your means? According to the Synergistics survey, for example, 13 percent of HELOC holders have tapped the lines for travel or other leisure pursuits.
ďBottom line: Your Hawaiian idyll will truly be more than just a memory if you end up paying it off over many years with interest.Ē
Your home is not a bank and tapping the equity in it simply because itís there or thereís a lot of it, is not how people get rich, itís how people spend more than they should. Iíve even heard some people advocate taking a home equity loan out to buy stocks. I have to admit that even I thought this was a good idea when I first heard it but upon closer evaluation it turns out to be just another example of using one tool when thereís another that is better suited for the task at hand.
If you are sophisticated enough to invest using credit, or margin as itís known, then you ought to do it properly. Letís assume that you have a $100,000 mortgage but your home is worth $300,000. You re-finance from an 8% interest rate to a 5% interest rate on a new $200,000 mortgage for thirty years. This will actually increase your mortgage payment in spite of the big drop in interest rate. Looking to get ahead you invest your $100,000 cash in the stock market and return a pretax profit of 12%. That leaves you with a net return before taxes of 7% and once taxes are considered youíre left with a profit of 5.95%. Thatís not bad and it is a profit you didnít have leaving the equity in the house.
But what if things donít go as planned? What if you return only 8% in your investment? That would leave you with only a 3% profit before taxes and 2.55% after taxes. Thatís hardly enough to keep up with inflation. Not to mention the fact that your investment could loose money and youíve eliminated some of the cushion that was your home equity. Was it worth it? Putting one asset at risk to buy or invest in another isnít always the best idea.