Cash-out Refinance and Invest in the Stock Market?

[gollygeebers]

The situation:

• I'm 33 years old.
• I've put all my resources into my 3 rental houses.
• The interest rate on all three houses is close to 4% on 30-year fixed.
• I currently have no retirement savings.
• I have approx. 200k in house equity.

The Question: Should I diversify my resources by doing a cash-out refinance on one of the houses and invest in Vanguard index funds?

[Retire-Canada]

What's your annual positive cashflow from each house and how much $$/yr do you need/want in FIRE?

How much equity are you gaining each year in total and how long until the mortgage terms are done?

[MaikoTsumi]

The question you're asking is whether you should borrow money to invest in the stock market?
Absolutely not. It sounds like you have an income problem, if you are thinking of doing this.  Debt can be a great tool for leveraging growth, but I think it would be wrong to force diversification with it.

[gollygeebers]

Thanks everyone,

The houses currently produce about 20k / year, which is enough for me to live on.

Sounds like the consensus is that I should not touch the mortgages and start funneling my resources into index funds?

When I do the long-term math (I could get a 7% return when borrowing at close to 4%) it seems like not a terrible idea, but I would have to pay closing costs and such, and then my monthly income would drop some, too (because the mortgage payments would go up).

[Seppia]

It seems like a spectacularly bad idea.

[Retire-Canada]

I've only got the house I am living in which is worth ~$420K. I have $80K equity at the moment, but once that grows I will pull some out and invest it assuming interest rates stay low.

Having $300K+ tied up in a house doesn't do me any good and whether I have a $300K or a $100K mortgage balance is irrelevant up until I have the cash to pay it off.

At the current time I'd earn more in dividends than it costs to borrow money for my mortgage. So that money can work for me while I pay off more of the house...at some point the harvested equity that's been invested will be worth more than the balance on the mortgage. That might mean I'll pay it off or I'll let the investments ride....depends on what's going on in the economy at the time.

[hodor]

Debt can be a great tool for leveraging growth, but I think it would be wrong to force diversification with it.

This doesn't make any sense to me at all, it implies you should only leverage to buy into the same asset class.

There are plenty of arguments for and against leverage so you need to decide what works for you and your risk tolerance. It is not a very MMM thing to do, so if you want to walk that path you would avoid it.

For me I am happy to leverage equity from a property to buy shares, there are things you should consider if you plan to go this way and if it is right for you.

[MaikoTsumi]

Debt can be a great tool for leveraging growth, but I think it would be wrong to force diversification with it.

This doesn't make any sense to me at all, it implies you should only leverage to buy into the same asset class.

There are plenty of arguments for and against leverage so you need to decide what works for you and your risk tolerance. It is not a very MMM thing to do, so if you want to walk that path you would avoid it.

For me I am happy to leverage equity from a property to buy shares, there are things you should consider if you plan to go this way and if it is right for you.

      Look, I have 5 properties that generate $25,000 a year in cash flow. Cash flow ranges from 18-25%. They also generate about $8,000 a year in principal pay down every year.  I bought below market value, as they all needed repairs when they were purchased.  That $25000 costs me negative $13000 in taxes due to depreciation(i.e. I pay no taxes on the cash flow and bank the capital loss carryover to offset future depreciation recapture).  I have approximately $170,000 in equity in these properties that I could tap if needed.   With that equity, I can buy 5-6 more properties for another $25,000-$35,000 in cash flow.  You can't do that with as much security and tax advantages in the stock market.  The world markets are at an unprecedented amount of leverage and risk at the current moment.  What I'm saying is, only a fool would tap that equity in today's market to buy stocks. Leveraging a hard asset to purchase that volatility right now, well, you're welcome to it.
    Using that cash flow to buy stocks or properties, I do both.

[MustacheAndaHalf]

"I could get a 7% return when borrowing at close to 4%"

The 4% debt is a certainty: the bank forecloses on your house if you don't make the payment.  The stock market returns are uncertain: you can't predict if S&P 500 will return -10%, 0% or +10% next year.  A good example is the "lost decade" where stocks earned 0% for 10 years.  If you have money you don't need for 10 years, then most likely stocks will go up by an uncertain amount.  But if you need cash flow to pay off the mortgage or for emergencies, investing in stocks adds a lot of risk.

Funneling extra money into stocks seems like a better idea than taking out a loan.  There's also the possibility of selling one of the rental properties to reduce your debt, and invest after cashing out.  With multiple properties that's probably not something you're willing to do - but that would be the way to diversify if feel vulnerable to the real estate market.  Are all 3 properties in the same geographical area?  (Some people keep rental properties after they move elsewhere)  If they are subject to the same real estate market, that's a risk as well.

[Bbqmustache]

Please, please listen to the naysayers above.  Borrowing to invest, esp. borrowing against where your family sleeps, is a REALLY bad idea.

[thunderball]

OP, please consider that you have a fantastic cashflow situation at the moment. 

If you want to diversify, I'd use another income stream and invest those funds.  Currently, your rental properties are subsidizing your living expenses...  you're essentially FIREd.  Why are you considering this again?

[Paul der Krake]

Displays of exuberant confidence like these are not a good sign...

My crystal ball says 15% correction by year end.

[Gonzo]

I don't know why you say you have no retirement savings.  You have equity in rental properties and they are generating income.  You can sell them or refinance them to tap the equity, or just keep the income stream.  This is just as valid as stocks and bonds. 

The risk is that your portfolio is concentrated not diversified.  And in most areas, real estate doesn't appreciate rapidly, especially when you consider upkeep and carrying costs.  I like to say that my house is a terrible investment.   

4% interest is fairly high, and it sounds like you have a lot of debt attached to these properties.  Paying that down is a pretty safe return assuming you retain plenty of cash on hand to deal with expenses.  Have you looked at refi to 15 or 20 year term to get a significantly lower rate like 3%?  I realize that will hurt your cash flow, but if you can sustain it you will build wealth faster.  Maybe just refi one of the properties if it's daunting. 

Can you use future income to buy stocks instead of more rental properties? 

I've made the decision to borrow against my house to buy stocks in a sense, so I don't consider your question a bad one.  I have more than enough in a brokerage account to pay off my house, but I don't.  The difference is I never did a cash out refi. 

I'm sure a lot of people will tell you the stock market is closer to a top than a bottom right now, though no one really knows.  In a way, your post is an omen. 

[Clean Shaven]

It's funny how the responses here have all been opposed to cash out refinance for investment, but if you go to any of the "should I pay off my mortgage" threads, you'll see a bunch of arguments against doing that.

It's the same question, isn't it?

OP's situation is a little different, if asking about whether to take equity out of a rental property and invest. (ie not taking it out of your residence)

[Retire-Canada]

It's funny how the responses here have all been opposed to cash out refinance for investment, but if you go to any of the "should I pay off my mortgage" threads, you'll see a bunch of arguments against doing that.

It's the same question, isn't it?

My post above  was pro-use of home equity for investing.

[gollygeebers]

Thanks a lot for the thoughts, everyone! Given all the unknowns, it's seems to be a speculatively interesting question. I'm still not quite sure what to do. The good thing is, there's no pressing need to change anything. As for next steps, I just opened a Vanguard account and put 3k into the Total Stock Market and am looking to start making monthly contributions.

I'll also be calling my mortgage person and asking what kind of refinance options there are, just to run the numbers. Maybe if I can get a 3% loan, and take out just a little bit of cash, then it would be a good move in the name of diversification.

To answer some of the Questions: One of the houses is in Portland, Oregon, and the other two are in Bend, OR. Both are solidly appreciating markets, but there is the 1/3 chance that a big earthquake will hit in the next 50 years, making the equation even more interesting :)

[Indexer]

I'm not going to tell you yay or nay, but here is the thought process I would go through if it was me.

We don't know what stock market or real estate returns will be in the future so it is impossible to answer with 100% certainty. I can say I wouldn't put a big bet on the stock market averaging 7% or more over the next couple decades. Returns may be lower, especially given how high current valuations are.

My rule of thumb for paying down debt VS investing: If the interest rate is <4% invest. >6% pay down debt. 4-6% it becomes a personal decision.

If your interest rate is less than 4% then I would look at cash flow. if you can't pay the mortgages you would be in big trouble. If you are confident this wouldn't be a problem even in a major recession then it sounds like it could be a good idea. I say 'could' because there are always unknowns. You are effectively taking on leverage to invest. It can boost returns, but taken too far to the extreme and you get Lehman Brothers.

It's funny how the responses here have all been opposed to cash out refinance for investment, but if you go to any of the "should I pay off my mortgage" threads, you'll see a bunch of arguments against doing that.

It's the same question, isn't it?

There is one slight difference. If you have a mortgage on your primary residence then it is a straight pay down debt VS invest argument. In this case we are talking about adding 'additional' debt in order to invest. It is a similar argument, but it has the additional risk that if cash flows become compromised you will have a harder time paying off the additional debt than you did just paying the original mortgage.

[SnackDog]

I would definitely cash out and invest in stocks. Long term, you will do better with stocks than what any mortgage costs. Someone said they chickened out in 2005 - by now you would have doubled your s&p 500 index investment.  You could do even better using the money to invest in more income properties, if that is your forte.

[Mighty-Dollar]

• I've put all my resources into my 3 rental houses.

You've got all of your eggs in one asset class basket, and probably all in one region. You pay higher taxes with real estate.

I would think about selling some of that property and investing in stock and bond index funds.

[Playing with Fire UK]

To answer some of the Questions: One of the houses is in Portland, Oregon, and the other two are in Bend, OR. Both are solidly appreciating markets, but there is the 1/3 chance that a big earthquake will hit in the next 50 years, making the equation even more interesting :)

What are the recourse rules in OR? If I lived in an earthquake zone with no recourse (ie if the house if worth less than the mortgage you can hand over the keys and walk away). I would have as much mortgage on the houses as I could.

[faramund]

There's also the question of 'how much'. If you borrowed 10% of your equity, and put it in shares, that seems almost a trivially safe and worthwhile thing to do (with qualifiers that the shares are suitably diverse, and not put in some high PE long shot hope).

How high your debt-to-asset ratio goes depends on your risk tolerance.

Me, I have a very high risk tolerance, but that's because I have multiple independent income streams, and if worse comes to worst, I could always delay retirement, so I'm substantially leveraged.. just so you know.

[FarmerPete]

You said your cash flow was $20k a year.  Is that including/Excluding savings for major repairs/renovations?  If you're making 10% income on your $200k principle, then why rock the boat?  I would either throw your cash at more rentals or dump some of the cash into an index fund.

[Crazycarl]

What about a HELOC? then you only pay the interest when you want/need to take out the money and can take out as little as you want....maybe do some DCA with it?
but then again, if you can pay more towards a mortgage, then why not use the extra payments to just pay into your brokerage account? then it just becomes a choice of Dollar cost averaging vs lump sum

What are your rates for the current loans/mortgages at?

[The Happy Philosopher]

It is interesting how you get different answers depending on how the question is framed. If you ask "should I pay down 4% mortgage instead of investing in the stock market" many people would say that is a bit crazy. Isn't pulling out equity and investing it essentially the same thing?

What if OP refinanced to put a down payment on another property? Would this also be dangerous? Isn't that similar to buying stock (although the difference is the stocks are more liquid).

What if the refi was used to purchase a basket of stocks with a 4% dividend yield? Would this matter?

I don't know the 'correct' answer, but I find the debate interesting. Whatever you do I would take a good hard look at cash flow. If you can refi and have a good healthy cash flow maybe the strategy is sound.

[Frugal D]

Agree with most here: bad idea!

The idea of it is not necessarily horrible, but the timing of it is. There is just nothing so compelling about the market right now that justifies the risk.

No, I don't know if the market is going to go up or down tomorrow, but everyone can agree that multiples are stretched to their general limits across all sectors.

Now if we have another '08-type sell off and multiples collapse to 8x, then there's probably an argument to be made. The problem with that is your rentals will likely also have declined in value giving you less leverage to play with.   

[gollygeebers]

You said your cash flow was $20k a year.  Is that including/Excluding savings for major repairs/renovations?  If you're making 10% income on your $200k principle, then why rock the boat?  I would either throw your cash at more rentals or dump some of the cash into an index fund.

Yes, 20+k, after accounting for anticipated repairs and such.

Lots of great info here, everyone. Thanks!

I'm traveling and haven't gotten a hold of my mortgage person yet, but I did put 3k into the Vanguard Total Stock Market and am excited to put in another 1k in a couple weeks, and keep contributing to it.

What about a HELOC? then you only pay the interest when you want/need to take out the money and can take out as little as you want....maybe do some DCA with it?
but then again, if you can pay more towards a mortgage, then why not use the extra payments to just pay into your brokerage account? then it just becomes a choice of Dollar cost averaging vs lump sum

What are your rates for the current loans/mortgages at?

Current rates are Just below 4%. Pardon my ignorance, but what is a DCA?

[Retire-Canada]

Pardon my ignorance, but what is a DCA?

Dollar Cost Averaging - is when you have a larger sum and choose to invest it in smaller chunks at a regular interval.

[gollygeebers]

Ah! Ok, I recently learned about Dollar Cost Averaging, but hadn't heard the acronym yet. Yes, I'll check into the HELOC, too. Thanks.