Should you refinance now? Why Mortgages are an insurance against falling Real-Estate prices

Everyone is saying now: refinance your mortgage because rates are falling down and you want to lock that low rate for the next 30 years.

Are they wrong?

Not really, but they miss the real points of taking a mortgage or refinancing: lower risk and higher return. Oh, and tax benefits as well.

Firstly, let’s quickly examine the argument behind “refinance when rates are going down.” It is really a simple one: pay some money now in closing costs of the new mortgage to create long-term savings due to the lower rate. If the net present value (the value of the savings in today’s dollars) is higher than the closing costs, it’s a good deal. If not, it’s not.

Two assumptions are being made when this argument is put forth. The first is that rates are NOT going to go down further. History, however, suggests that when rates start going down (or up) they continue to do so for a while. The reason is that macro-economic factors play over longer terms than the effects of the overnight rates of borrowing (that’s the rate the Fed controls) that really affect short-term borrowing. Additionally, the Fed tends to be conservative and rarely make really big rate cuts, but rather tend to make gradual cuts over a period of time. Combine the two, and the expectations for a recession, and it means you probably should not jump to refinance quite yet.

The second assumption is that all you do is replace one loan with another. What if, and you have to bear with me here before you jump up shouting, you took MORE money out, or low and behold, you mortgage your house to the hilt?

Wait, I know what you are going to say about the mortgage crisis, and foreclosures, and all that. As I said, bear with me a while.

Douglas Andrew, the author of the NY Times best sellers, Missed Fortune 101, and Last Chance Millionaire, is champion of the Equity Management movement, and the biggest proponent of pulling out equity in order to invest it in safe investments. Mr. Andrew argues as follows, “The criteria by which we should evaluate our investments, as well as liabilities and assets, are Liquidity, Safety, and Rate of Return.” “Then,” Mr. Andrew says, “if you get tax benefits, this is the cherry on top. It is not the reason to make decisions, but it is certainly a nice feature to have.”

Why does Mr. Andrew argue for Liquidity, Safety, and Rate of Return as criteria? To understand this argument, we should think about what is risk.

Usually, the financial world considers volatility to be “risk.” Indeed, volatility can pose risk; at least the downside of volatility might do so. However, volatility is not risk, only a driver of possible risk.

The following definition is critical to understand risk, and how to evaluate it, something which even notable economists have a problem with.

Risk is: “Not having what you need or want when you need or want it.”

It is a very simple definition but very powerful. When I defined it as such, it illuminated for me many paradoxes in human behavior, as well as economic and financial problems. Recently, Howard Kunreuther, one of my former mentors and the director of the Risk Management and Decision Processes center at Wharton, together with Dave Krantz, from the Psychology department at Columbia University, wrote an article for the Judgment and Decision Making Journal in which they suggest that we make decisions based on goals, and not as economist been claiming we do, namely by evaluating options’ utility (economic speak for benefits or costs) regardless of our objectives. This new, goals based approach is indeed more in line with the above definition of risk. Indeed, Professor Kunreuther and I are discussing future research and articles about it.

The problem with mortgages is that the whole financial industry, except for Douglas Andrew, and not surprising, many mortgage brokers and bankers themselves, focuses on foreclosures consequences and does not examine what are the sources of risk in real-estate and mortgages. The common assumption is also that they money we borrow is spent and not invested in a safe side-fund.

We will assume that we put the equity we pull out into a good safe side fund that cannot lose money. It is an important assumption to remember in order to understand the rest of this article. As for the side fund, there are such risk-free investments that provide very good (long-term) returns at low cost, but those options are not the focus here.

Sources of Risks

The first source of risk in mortgages is the inability to make payments on the loan, resulting in foreclosure. This means that you might not have the house you want or need. However, when do we face such risk? Most of the time, if we had NOT gambled on short-term increases in real-estate prices using introductory rates knowing we cannot afford the full payment on the loan, this risk comes from losing a job, health problem, and similar unexpected events. In this event, if you DID NOT pull the money out of the house and put it in a (safe) side fund, you are indeed in a bind. The banks, as Citibank, in an ironic twist, found out recently when it needed to borrow money to cover mortgage defaults losses, will not loan you the money. As they say, “it is better to have the money and not need it, then to need it and not have it.”

If, however, you did pull equity out and put it in a side fund, you can use the side fund to cover payments until you recover. In the worst case, you can forgo the house, which might be emotionally difficult and painful, but you would still have your money in that side fund, and you would be able to start anew.

In fact, unless you don’t have any mortgage, the LOWER your mortgage balance, the MORE you are at risk of foreclosure!

The reason is simple, and even more critical to understand now when real-estate prices are falling. Banks don’t want to foreclose on properties because it costs them on average $50,000 per foreclosure, and that’s only direct costs of legal fees and such. It costs them more due to higher borrowing rates they face – much like us, banks are rated on “credit worthiness” and the higher a bank’s foreclosure rate, the more it get charged. Therefore, they foreclose on properties they can make money on and try to avoid foreclosing on properties they would have to sell at a loss. Therefore, the lower your mortgage balance, the more likely the bank can get rid of it in the foreclosure auction, or at worse, take it back and sell it as a Real Estate Owned. With falling real-estate prices, banks are even more concerned about foreclosing on a property with a high mortgage balance because by the time they get the house and are able to sell it, prices would be even lower.

What is the lesson?

Pulling your equity out and putting it in a SAFE side fund reduces your risk of foreclosure!

The second source of risk, and other minor issues such as your return on investments and taxes will be discussed in the next blog.