The great Greek Mathematician Archimedes once said "Give me a lever long enough and a fulcrum on which to place it and I shall move the world." A similar claim is being made these days about a different type of leverage, though this claim has no basis in fact and would not stand up to Archimedes logic.
What lever am I referring to? Home mortgage debt.
The newest pitch from the “charlatan” advisor community is to leverage your home by doing a “cash out” refinance and using the money to buy investment products. This isn’t exactly new, though they have added a few twists.
The first twist is the use of the latest mortgage creation, The Option ARM. The Option ARM mortgage is an adjustable rate mortgage that gives you four different payment options. The four payment options are:
- The minimum payment (negative amortization)
- Interest Only
- Pay off in 30 years
- Pay off in 15 years
I have many problems with this loan, the first being that it is an adjustable rate mortgage and for the most part I don’t like adjustable rate mortgages (especially in an era of record low interest rates). The second is the structure. Without getting into the confusing details the minimum payment is way below what the actual interest payments are on the loan which means that if you only make the minimum payment you will be adding to the loan balance (called negative amortization), not a smart move. Option ARM loans should only be used by in certain situations and the people purchasing them should fully understand what they are getting into.
The pitch essentially by these charlatan advisors is to use this new Option ARM loan to refinance your existing property and use the extra cash and the extra cash flow to invest in your retirement. The theory is that you can make more money by investing than letting is just sit as home equity. To give you an idea of the difference in monthly cash flow with the Option ARM loan I will show you the payments on a $100,000 loan, as follows:
30 year fixed rate 6% $600
Interest Only 6% $500
Option ARM 1.25% Start Rate Minimum Pmt $333
Additional monthly cash flow over Fully Amortized loan in 1st year: $267
As you can see, you have freed up $100,000 in cash, plus $267 in cash flow per month to use for investments. This sounds great, except that you are not paying off the $100,000 loan, it is growing by about $167 per month and you don’t have a fixed rate, which means that if interest rates get out of hand you will have a major problem. The goal is to get a better rate of return after tax than the interest you are paying, the problem is that you are exposed to interest rate movements and the strategy only works if interest rates stay low, if they don’t, you lose. Even if rates do stay low you may lose because of the investments you are in, which brings us to the second part of this bad idea.
Typically the investments being offered by the people touting this strategy are annuities. It used to be just variable annuities, but now these charlatans have discovered another annuity with a higher commission, the Equity Indexed Annuity. Both variable and equity indexed annuities are loser propositions. The variable annuity is excessively expensive, typically in the 3-4% range annually, and the equity indexed annuity simply won’t perform as advertised. The reason either of these products are utilized is because they generate large commissions, anywhere between 7 – 12%. Of course, the really bad advisors will try to sell you on dumping the extra cash and cash flow into permanent life insurance policies which generate commissions that are much, much higher, but usually provide little value and most likely will hurt your financial situation long term.
This strategy sounds great to the unknowing public, but in reality these strategies are exceptionally dangerous to one’s financial health. The “advisor” gets paid handsomely, as follows:
$100,000 Mortgage
Mortgage Commission $1,000 - $2,000
Annuity Commission $1,000
Total Commissions $2-3,000
Of course most of these sales jobs are on much higher amounts; just imagine the commission on a $500,000 cash out refinance combined with annuity commission.
I do not endorse the above strategy, I think it is dangerous. This is not to say that it couldn’t ever work, just that the probabilities are low and gambling with your home is not the best of ideas. The Option ARM mortgage is not in and of itself evil, it is a legitimate mortgage product, but it needs to be used carefully and in the right situations.
Utilizing leverage is an age old strategy, but not one that most people should apply and definitely not by using the above mentioned strategy. If an “advisor” offers to refinance your home and then use the proceeds to purchase investments (especially annuities) you should be on guard and get a second opinion, the transaction is most likely not in your best interest.
