The Mysterious Cash-In Refinance

Today I am going to explain something complicated, so pay attention. Particularly if you write for the Wall Street Journal. My topic has to do with theTwo-story_single-family_home exotic topic of homeownership.

Many homeowners owe money on a special type of loan collateralized by the house, called a mortgage. Sometimes, they “refinance” these mortgages, often to take advantage of a lower interest rate. Generally, that is no more complicated than paying off lender A with money borrowed from lender B.

However, and here is where it gets really confusing, sometimes the money from lender B is not the exact same amount owed to lender A. If more money comes from lender B, then the refinancing is termed “cash-out.” It is called that because the borrower actually leaves the closing with more cash than they had previously.

Conversely, if less money comes from B than is owed A, then it is a “cash-in” refinancing. The borrower will have less cash on hand after the transaction than he did before it.

In the Good Old Days, cash-out refis were common. House prices were buoyant and credit standards were notional. It was easy to find Bs willing to lend more money than was owed to A and on great terms. Today, house prices are at best stable, but far below previous peaks, and credit standards are strict. So cash-in refis are more popular.

The key insight here, and I admit that it is subtle, is that cash-out and cash-in refis do not make the borrower richer or poorer. All that has happened is that the borrower has increased or decreased his debt in exchange for some cash. Homeowners do not make money in cash-out refis, even though they may leave the closing with the happy feeling of liquidity. And cash-in refis do not cost money, even if they may feel like an expensive investment.

Got that? You might want to re-read the last few paragraphs until it’s all straight in your head.

Received wisdom has it that in the Good Old Days homeowners commonly did cash-out refis and treated the resulting funds as if they were lottery winnings. Only years later did they realize that they had actually borrowed more money and that the refi did not, in hindsight, make them richer. It was a hard lesson to learn, but we as a nation have now wrapped our heads around the true nature of the cash-out refi.

Cash-in refis, on the other hand, are still mysterious. Over the weekend The Wall Street Journal ran Doubling Down on Housing: Record-Low Interest Rates and a Scary Stock Market Are Prompting Investors To Sink Even More Money Into Their Homes. The sunk money in question is not for landscaping or a finished basement. The article is mostly about cash-in refis.

Some intrepid homeowners are intentionally taking a loss on their current house—and writing a big check to retire their old mortgage—in order to buy twice the home for not much more money. Others, eschewing conventional personal-finance advice, are even opting for "cash-in" refinancings, paying thousands of dollars out of pocket to settle old loans—and then taking out new mortgages with lower payments, shorter durations or both.

To be fair, taking advantage of lower prices by selling your current abode and buying twice the home could be called doubling down on housing. (Although it is a stretch if the new place costs “not much more” than the old.) But in no sense is paying down some of a mortgage, even in order to refinance it, doubling down on housing or sinking more money into a house.

Perhaps the very well covered phenomenon known as strategic default is confusing the folks over at the WSJ. A homeowner who owes much more on the mortgage than the house is worth, and who has the option to extinguish the debt by signing over the deed to the house, would be foolish to pay down the mortgage with spare cash. That would be sunk money in the sense of wasted money.

But as I have written previously, strategic default is more concept than reality. Until I see some hard numbers I am going to assume that it exists on a scale somewhere between anecdotal and urban legend. And if you exclude that special case it ought to be obvious that a change in the level of mortgage debt has no relation to the level of investment in, or exposure to, housing. A person who owns a house will experience the same profit or loss when the value of that house goes up or down regardless of how much he owes on it.

As an aside, loathe as I am to defend “conventional personal-finance advice,” it is not at all clear to me how a cash-in refi runs against it. Granted, it is not a topic much discussed. But paying down a mortgage early does come up in the literature with some frequency and is usually treated positively.

The WSJ article includes a long sidebar asking “Should You Invest Your Cash in a Refinance?” It contains an example provided by Jack Guttentag, who calls himself the Mortgage Professor and who is identified as an emeritus professor of finance from Wharton by the WSJ.

A homeowner has an $809,000 mortgage at 6%, which he refinances to a $729,000 mortgage at 4.375%, with the help of $80,000 in cash. The good professor tells us that the “Return on the $80,000 investment: [is] 10.4% annually for five years.” He does not explain his math and I am at a loss as to how to reproduce it. I really tried.

To begin with, the $80K is not a proper investment, as the homeowner is neither buying something nor lending it to anybody. It is, at most, analogous to an investment, something that “pays” money in the sense of a reduction in future interest payments. And in that sense, the rate of return on the $80K is the same as it is for paying down any debt, that is, it is the interest rate on that debt, in this case 6%.

The argument could be made that the $80K should be credited not just with the interest no longer paid on it but with the savings on interest on the other $729K. All in, the interest paid is reduced by $16,646 per year. On $80K, that is a notional return of 20.8%. (Perhaps the professor cut this in half to be safe?)

But thinking of the cash for a cash-in refi this way does not really work. Refinancing to lower your interest rate is a great idea that will save you money, but it is not an investment. Would the rate of return on a conventional A=B refi be infinity? What if the homeowner did not have the $80K but had to borrow it?

The basic should-be-obvious principle here is that cash-in refis do not increase your investment in real estate nor do they make you poorer, any more than cash-out refis decrease your investment in real estate or make you richer. A cash-in may be often be a good move, but confusing it with an investment in real estate is not helpful.

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