Refinancing Your Rainy Day Fund

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With all the news about underwater mortgages and the depressed housing market, it’s easy to forget that most homeowners do have equity. With mortgage rates at record lows, would it make sense to take money out of your home – even if you don’t need to – for an investment or a rainy day fund, perhaps?

The math can make this move look good, but the risks are sobering.

In the 1990s, some experts argued that growing home values provided a perfect source of money for other types of investments, especially stocks. The idea was simple: if you could borrow against your home at a 7 or 8% mortgage rate and invest the money for a 12% return on the stock market, you’d make an easy 4 or 5%.

This idea doesn’t get much circulation these days, probably because the stocks have suffered two crashes and produced a long run of disappointing years since 2000. But many American corporations are using a similar strategy, borrowing at today’s low interest rates and either investing the money or setting it aside so they won’t have to borrow in the future, when rates are likely to be higher.

With a home, equity is the difference between the property’s value and the outstanding debt. If your home was worth $400,000 and you owed $150,000, you’d have $250,000 in equity. These days most lenders limit debt to 80% of the property’s value, so you could carry up to $320,000 in debt on the home. It shouldn’t be too hard to borrow $100,000 more than you currently owe.

The easiest approach would be to take out a home equity loan. Unfortunately, most home equity installment loans, which have a fixed rate on a lump sum, are charging more than 7% interest, according to the BankingMyWay.com survey. That’s fairly steep. You can get a home equity line of credit, or HELOC, starting around 3%, according to the rate search tool. But HELOC rates float month-to-month, so you don’t know what you’ll be charged later.

An ordinary, 30-year fixed-rate mortgage therefore looks like the best option, charging about 4.5%, according to the BankingMyWay.com survey. The real cost would be only 3.38% after the mortgage interest deduction on the federal tax return, assuming you were in a 25% tax bracket.

If you took out a new $250,000 loan and used $150,000 to pay off the old loan, you’d have $100,000 left for a rainy day, or a future opportunity. To keep it safe, you could also buy a five-year certificate of deposit.

Those CDs yield an average of about 1.7%, according to the survey, but the rate search tool shows that some of the best pay around 3%, or 2.25% after taxes if your earnings were taxed at 25%.

This approach is a money loser, but not a big one. On an after-tax basis, you’d pay 3.38% and earn 2.25%, so you could have a $100,000 fund at a cost of 1.13%, or a little over $1,000 a year. Because the mortgage rate would be fixed for the life of the loan, you could turn a profit if CD rates were to rise above the loan rate.

What’s the downside? Refinancing the entire mortgage would likely involve thousands of dollars of closing costs, and taking out a bigger mortgage could make it harder to get other loans. Still, it’s not a bad way to produce a reserve fund while borrowing costs are extraordinarily low.

For a more aggressive approach, you could invest the fund in the stock market. Over long periods, stock returns have averaged about 10% per year, and they do much better than that fairly frequently.

Of course, there are no guarantees with the stock market. You could lose money yet still have to make payments on the bigger mortgage. The odds of making money in stocks improve if you stick with it for the long term, but that means shouldering those payments for a long time. You could not count on your investments generating extra cash to help with those payments, so you’d need plenty of income to cover the costs.

Also, with a bigger debt on the home it might be harder to sell for enough to pay off the loan if home prices were to take another dip.

So tapping home equity to fund other investments entails plenty of risks. It’s probably not a good idea unless you’re an experienced investor. But it is an option to keep in mind as you refine your long-term financial strategy.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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