One thing I really like about owning real estate is the ability to build equity over time through principal pay-down and appreciation. However, the challenge homeowners have is how to access this built up equity so they can use it. One answer is to refinance the property. I have two other blogs where I discuss, “How refinancing works.” (https://realestateofhawaii.com/real-estate-blog/how-does-refinancing-a-mortgage-work/) and, “Should I Refinance my Mortgage Now?” (https://realestateofhawaii.com/real-estate-blog/should-i-refinance-my-mortgage-now/).
I appreciate it when friends, investor colleagues and clients want to discuss their financial situation, debt and what I think the optimal use of leverage is in their scenario. In this blog, I wanted to touch upon a mistake I see homeowners make when it’s time to refinance. So, for the sake of this discussion, I want to address the situation of homeowners refinancing their home to access their equity so they can use the funds for whatever reason they want. Maybe it’s to pay for a big renovation, or maybe it’s to have the down payment available to upgrade to a new home. Some of my clients use this method so they can buy first, move to the new home, then sell their old home, allowing for just one physical move and not leaving the market. The mistake I wanted to talk about in this video is how the homeowner structures the debt refinancing.
So, the typical refinancing structure would be to get a new fixed rate amortized loan, a home equity line of credit, or a combination of both. Again, there is no one size fits all, and it largely depends on your current earning power, but my overall philosophy would be to minimize the amortized loan as much as possible and maximize the home equity line of credit amount as much as possible. When I say maximize, I would say keep the line of credit amount to a manageable amount to where you would be able to pay down the principal in 3- 5 years, the rest of the debt would be in the fixed rate loan. And if your goal is to use the funds to upgrade to a new home, I’d refinance the existing loan balance, if any, with the new first mortgage, and have the home equity line ready to tap into. The mistake I’ve seen borrowers do is they refinance on their first fixed term mortgage with a bigger fixed rate mortgage and have a small home equity line of credit.
The problem here is that the borrower now has a lot of extra funds available from the big refinanced first mortgage, not providing any benefit for them, because they haven’t purchased their new home yet, but they are paying amortized, front-loaded interest on the related debt. That’s why in this case it’s better to use the flexibility of the line of credit.
It bothers me a bit as to how they decided to set up their debt structure this way. And I’m not blaming anyone because hindsight is 20/20. I do know, however, that loan officers and lenders get compensated way more for initiating 30-year fixed mortgages than home equity line of credits. And that makes total sense since a 500k mortgage will earn the lender so much more interest income than a 500k HELOC that may not ever be tapped into.
Again, I’m not pointing fingers at all. And besides, the “traditional” way of thinking is to lock in that rate in a 30 year fixed mortgage so you know exactly how much you’ll be paying over the next 30 years. In that sense, I’m NOT traditional. But, yes, that, to me, is the biggest mistake borrows make when refinancing their homes. I don’t want you to make that mistake too, so reach out to me if you ever want to discuss your situation.
In the words of Mahatma Gandhi, “It is unwise to be too sure of one’s own wisdom. It is healthy to be reminded that the strongest might weaken and the wisest might err.” I’ll see you next week!
