Think Outside Of The Box
As you know, we schedule periodic reviews with our clients. Recently, we have been considering an unusual path for those with student loan debt, and I want to share the reasoning behind our recommendation.
When we see an opportunity for our clients to refinance their mortgage or other debt at a lower interest rate, we mention it to the client. And when making this consideration, it’s common to compare past mortgage rates with new mortgage rates or past student loan refinancing rates with current ones.
Currently, mortgage rates are at an all-time low, and real estate market values are up. Because of this, it’s a good environment to do a cash-out refinance. In a cash-out refinance, you refinance your existing mortgage for a larger amount than the original mortgage, converting your home equity into cash. You can then use that cash to pay off student loans, credit cards, or car loans.
You essentially replace your student loan and/or car loan with a new mortgage loan that has a lower interest rate, and the 30-year amortization enables you to stretch the repayment, maintain a higher cash flow, and save more money each month moving forward.
What Should I Do With The Money? Repay Debt Or Invest
Now that you have a large amount of cash on hand, you may be asking. “Why not just invest the cash as a lump sum? Wouldn’t that give me a greater long-term return than using the cash to pay off existing loans?”
If you are comfortable investing the cash from a cash-out refinance, it’s possible that the investment could earn more than the interest you would avoid by paying down student loans or other debt.
In my opinion, eliminating debt is not the goal; this comes at a hefty price and is an inefficient path to wealth. The goal is to efficiently increase net worth, which is the result of subtracting your total liabilities from your total assets.
If I take out a car loan with a 3% interest rate and use the cash I would have spent on the car to make an investment with a 5% return, am I increasing my net worth more by paying cash for the car or using the loan? The latter, of course.
Even if your ultimate goal is to be debt-free as soon as possible, you can achieve that goal faster by using temporary debt to increase your net worth. Rather than paying extra principal payments on your mortgage, you could invest those same payments and potentially pay off the loan faster.
The spreadsheets below compare the net worth of a person repaying a $700,000 mortgage over 15 years at 3.125% (Spreadsheet 1) versus a person repaying the same mortgage over 30 years at 3.5% (Spreadsheet 2). In both scenarios, the income, expenses, and discretionary income that can be allocated between debt and investments are the same. The savings balances are based on market returns between 1987 and 2017.
In Year 15, the savings balance for the person with the 30-year loan is $8,523,041, and the remaining debt owed is $438,351. If this person were to say, “I’m tired of this debt, let’s pay it off,” they could sell $438,351 worth of shares from their brokerage account. Ideally, these would be shares with a low unrealized gain, but for this comparison, we will assume the person has to pay a 15% capital gains tax on all $438,351. After $65,752 of taxes, the total mortgage payment is $504,103.
After subtracting $504,103 from the Year 15 savings balance of $8,523,041, the remaining balance is $8,018,938. This value is $571,656 more than the Year 15 savings balance of the person who chose the 15-year mortgage at 3.125%.
Spreadsheet 1
Spreadsheet 2
The Length Of Your Repayment Matters
If you prefer to reduce your debt because you are uncertain if your investment would earn more than the interest you would pay, you could use the cash from a cash-out refinance to pay off your student loans and other higher-interest debt. Using the equity from your home does not take away from the appreciation you will gain over time.
When you refinance student loans through a private institution, you can typically choose between a 5 year repayment term at the lowest rate or a 20 year repayment term at a higher rate. The 5- and 7-year fixed rates are similar to those of 15- and 30-year mortgage rates.
If you have equity in your home, you can withdraw that equity through a cash-out refinance, pay off your student loans, and secure a similar fixed-interest rate but with the ability to repay the loan over 30 years instead of 5 or 7 years.
The longer 30-year amortization allows you to increase what you can invest now, which will increase your net worth more over time (as shown above), assuming your earning rate is higher than your borrowing rate.
Opportunity Cost Is Just As Bad As Paying Interest
Short-term debt repayment can consume a large amount of your discretionary income, delaying what could be invested now. Studies have shown that the pain of losing is twice as strong as the joy of winning. This phenomenon explains why some people choose to pay down debt and avoid interest rather than investing the money with the possibility of gaining more interest in the years to come.
The opportunity cost of not investing the cash being used to repay debt is a loss that should be given equal consideration and weight to that of paying loan interest.
Spreadsheet 3 illustrates a person who chose to use all of their discretionary cash to aggressively repay their student loans. At Year 30, this person’s net worth was $826,336.02 less than it would have been had they repaid their student loans over 10 years (Spreadsheet 4).
Spreadsheet 3
Spreadsheet 4
The Tax Benefit
For most of you, student loan interest is not deductible. The deduction phases out completely at a certain income level and unfortunately it’s a low enough number that it prevents most physicians and dentists from being able to deduct a portion of the interest on their student loans. A single filer must have a Modified Adjusted Gross Income (MAGI) of $80,000 or less and couples filing jointly would need a MAGI of $165,000 or less. The increase in your mortgage balance from the cash out refinance is not deductible as qualified mortgage interest either.
What’s interesting is even though student loan interest may not be deductible, the interest on the loan balance from a cash out refinance may be deductible if used to invest. The deduction applies to interest on money borrowed to buy property that will produce investment income—interest, dividends, annuities or royalties—or that you expect to appreciate in value. Income from a short-term rental property is considered business income and one is able to deduct 100% of the interest against business income from the investment. If the money is used for investment use rather than business use, the interest is 100% deductible as “investment interest” against investment income, assuming you are itemizing deductions, and carried forward if not currently deductible. Interest incurred for an investment in a "passive activity" doesn't typically qualify for the investment interest deduction; however, it can typically be deducted as an expense item for the operation of a long-term rental property. It is important to track the use of the "cashed out" funds to protect the applicable interest deduction.
If you were to use the cash from a cash out refinance to invest rather than reduce or consolidate debt, the interest may be deductible. Before proceeding, we would recommend that you consult with a CPA or tax attorney to determine how the interest would be deductible in your specific situation.
What Makes The Most Sense
You may be wondering what to do after reading this article. If you have substantial equity in your home, that money could be put to good use in this low interest rate environment by way of a cash-out refinance or home equity line of credit.
Investing the cash is one option. If markets behave as they have in the past, you could increase long-term net worth by investing the proceeds instead of repaying other low-interest debt.
However, if you choose not to invest the proceeds, a cash-out refinance will help you consolidate debts that have higher interest rates and shorter repayment terms. Lowering your interest rate and lengthening your repayment schedule could increase your long-term net worth by giving you more discretionary income to invest now.
When deciding to do a cash-out refinance, you should always consider the potential value of your home and when you may choose to sell. You should always maintain enough equity in the home to account for closing costs, commissions, and value variations in the real estate market. The cost of refinancing will not be worth it if you need to move in the near future.
If you do plan to move soon, consider investing the cash you receive at closing rather than rolling that money into your next home as equity. We are happy to contact mortgage lenders we’ve worked with over the years or those you are currently working with to see which strategy would be most helpful for you.
And if you’re wondering if a cash-out refinance is the right choice for you, please reach out to us. We are here to help you navigate your financial future.
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