With home values and investment markets on the rise, homeowners may be tempted to refinance their mortgage to cash out their equity and invest it in other assets.
And there’s good reason. Homeowners’ equity in real estate rose from $8.87 trillion in the second quarter of 2013 to $13.85 trillion in the second quarter of 2017, according to the Federal Reserve. Plus, the S&P 500 and Dow Jones industrial average continue to notch record highs.
Using refinance money to pursue these cash and market opportunities is a sophisticated strategy that can offer rewards, but there are also costs and risks.
Should you do it? Maybe yes. Probably no.
Here are some important questions to weigh and expert advice to help you decide whether to use a cash-out refinance for investing.
1. Can cashing out to invest be profitable?
The answer to this question depends on your costs to refinance and how successful you are at investing your cashed-out equity.
To refinance your mortgage, you’ll have to pay closing costs or accept a higher interest rate or loan balance to avoid them.
If your new loan has a lower rate, your monthly interest expense might be lower. If it has a higher rate or longer repayment term, you could pay more interest over the life of your loan. You’ll also have to pay interest on the money you borrow to invest.
Investing isn’t free either. You may have to pay transaction fees or hire an investment adviser. Most mutual funds involve percentage-based marketing fees as well.
The refinance-to-invest strategy also has income tax implications. The additional interest you pay might be tax-deductible. You might have to pay tax on your investment gains or be able to write off your losses. You should discuss your situation with your tax adviser.
2. Is cashing out to invest risky?
In short, yes, it is risky to refinance your home to take cash out to invest.
You could lose some or all of the money you invest. Investing is inherently risky, and it’s extremely difficult to time the financial markets.
“People think about accessing their equity when the market has been going up for a while,” says Gary Silverman, founder and CFP professional with Personal Money Planning in Wichita Falls, Texas.
“Doing so means you borrow money and pay interest on it because you think you’re going to do better than what the loan costs you. That’s very presumptuous,” he says.
The strategy might be more effective if you invest in a down market, but even then you could lose money. The opportunity might seem less enticing, and you might not have much equity in your home.
3. Are there other risks?
Yes, you can expect more risks.
Regardless of your investment outcome, you’ll still have to pay back the extra cash you borrowed, says Elise Leve, senior loan officer at Citizens Bank in New York.
“The risk is having a larger mortgage with higher payments that you will be stuck with for the life of the loan,” Leve says.
If you can’t afford that higher payment, you could lose your home.
Brian Koss, executive vice president of Mortgage Network in Danvers, Massachusetts, warns that risking your equity “can do substantial damage to you and your family if things don’t work out.”
A less risky strategy is to figure out how much extra you can afford to pay each month for your mortgage and then use that to invest.
“You could put the difference toward a diversified portfolio of investments over time, so you’re able to spread out your risk,” Koss says.
4. Are there ways to lower the risk?
Rather than invest your cashed-out equity in stocks, which could be volatile, overvalued or both, you could buy high-grade bonds that pay a higher rate than your new mortgage, says Mike Windle, retirement planning specialist at C. Curtis Financial Group in Plymouth, Michigan.
“If you can get a bond that is paying 5 percent a year and your mortgage is 3.5 percent, then you are making money, earning potentially tax-free income and getting a write-off on your mortgage interest,” Windle says.
The catch is that you have to plan to hold the bonds until they mature to eliminate the market and rate risks with this strategy. Otherwise, “this would be a foolish investment,” Windle says.
Another option might be to buy a fixed index annuity, or FIA, that offers a higher return than your mortgage. An annuity is a guaranteed stream of future payments that you can buy from a life insurance company. An FIA is an annuity that offers a minimum guaranteed rate with a potential upside based on the stock market’s performance.
Even so, don’t take out a variable-rate or adjustable-rate mortgage or count on the income from the bonds or annuities to make your mortgage payment.
5. What’s the bottom line?
Before you decide to refinance to invest, total your expected costs and a realistic estimate of your expected investment returns. Factor in the income tax differences and think hard about whether you’re truly willing to accept the risks.
If refinancing makes sense for you without the cash-out, consider the two strategies as separate financial decisions. The key question is whether you expect your after-tax return to exceed your costs.
“Is it worth the very real possibility that you’ll end up in a worse financial position?” Silverman asks. “For most people, the answer is no.”