The housing market has been going up, and as a result, a lot of investors and homeowners are finding themselves benefitting from substantial appreciation on their home values. Investors often approach me with the problem of too much “lazy” equity in their homes.
Sophisticated investors know the amount of equity they have in their properties and closely monitor the return on equity of their investment — that is, the percentage of return in comparison to the amount of deployable equity, or how much they would net after a liquidation. This is different from the return on investment, which is the amount the initial capital investment makes off a down payment.
With the rise in home prices, people are looking to optimize the equity trapped in their home. In this situation, there are three options for redeploying the equity: sell the property, cash-out refinance, or take out a home equity line of credit (HELOC). Consider the strategy known as mortgage recasting or rate arbitrage on of those options in order to pay down your current mortgage.
First, let’s talk about good debt versus bad debt. An 18% interest rate paid on something like a credit card is bad debt. But taking a 4% HELOC or loan from your life insurance policy can be good debt. Especially if you are putting the loan proceeds into private note fund at 10%, an apartment private placement at 15%, a rental property at 25% or another higher risk/return partnership or development at 30%. What you do with the liquidity from your mortgage debt is what really matters — just don’t buy jet skis or other doodads with the money.
You assume when you buy a house that it will go up in price. Historically this has been true, but it’s not guaranteed to go up in the future. Mortgage debt is how most people can afford homeownership, whether or not they are responsible enough to commit to a 30-year loan or can afford the monthly payment. The unavoidability of mortgage debt is one of the myths I blindly followed to buy my first primary residence in 2009. You hear of it often from bankers and lenders, most of whom are simply acting as salesmen for big banks and get compensated when you originate a loan. They are not always acting as a fiduciary.
A traditional mortgage is where you have a 30-year amortization schedule where you make payments in the same amount for 30 years and all the interest is paid upfront. In the first few years, a huge majority of your payment is going toward interest. When the majority of homeowners move before the end of the 30-year mortgage, brokers love it because they get compensated with origination fees when a new loan or refinance happens, and banks love it because the amortization clock has been extended and the customer is again put into the front-loaded majority interest portion of an amortized loan.
Mortgage rate arbitrage turns the tables on this situation.
Take out a HELOC — credit borrowed against the equity in your home or any other loan that is based on simple interest, not amortized interest. This is a liquid line of credit that you can put money into and out of without penalty. Many people call these “debt-destruction weapons,” which is illustrated when you take a spreadsheet and compare simple interest and amortized interest against you.
In this strategy, you are taking money out of your HELOC (simple interest) to pay off your mortgage (amortized interest). This pushes down your interest paid every day since the HELOC with simple interest is calculated with an average daily rate (ADR). If you are paying 5% on your HELOC, you are paying 5%/365 or 0.0137% per day. Your ADR is 0.0137%. If you borrowed $100,000, you are paying 0.000137 x $100,000, or $13.70 per day.
On the flip side, amortized loans are front-loaded with interest and great benefit your lender, not you.
Mortgage Rate Arbitrage Key Considerations
1. Calculate your low-stress frequency. To reduce the headache of making payments to your mortgage with amortized interest every day or week, you need to figure out what is an effective amount to “chunk” these payments to your mortgage from the HELOC. Most people start out in quarterly to annual increments.
2. Your frequency dictates how much you are going to take from your HELOC to apply to your mortgage payment. Be sure you are maintaining a positive cash flow status in your personal budget.
3. An advanced strategy is to put your income into your HELOC and utilize your HELOC as your checking account.
4. Before you begin, evaluate how stable your monthly income and expenses are. Someone in a stable government job might want to be a little more aggressive and pay off your mortgage with bigger amounts from your HELOC. If your employment is unstable or your salary irregular, you might want to calculate a rolling 6- or 12-month average and base your chunking amount on that. Often this requires a cash flow plan in the form of a spreadsheet and a little financial guidance from someone who has employed this strategy before.
Though a sound strategy for many, this mortgage rate arbitrage process is not right for everyone. Avoid if:
• You need to have positive cash flow in your personal finances due to low income or budget is too tight.
• You do not have a credit score of 620 or higher needed to secure a HELOC.
• You do not have enough equity in your home to obtain a HELOC.
• You are an incredibly efficient, sophisticated investor already growing your money at greater than 15% per year. You might be better off investing in what you do best.
In the end, mortgage lenders are trying to extract every bit of revenue they can via amortization of loans. By using simple interest in the form of HELOCs to pay down your current amortized debt, you can more quickly pay down the principal on your loans, saving significant money over the lifetime of your loan.