A new reader of The Dough Roller sent me an email asking how she should invest $15,000. She initially considered investing in P2P loans with Lending Club or Prosper, which is how she found my site. But now she wonders if she should use the money to refinance her mortgage instead. Here are the details she provided about her home and current mortgage:
- Home: Purchased in 2005 for $230,000 with 5% down payment
Mortgage: 5-year variable rate @ 6.375%
Rate Adjustment: In 2010, the rate could adjust to as high as 11.375%
Current Balance: $214,000 (thanks to some extra principalle payments)
Home Value: Home is currently worth $215,000
Other Debt: One car payment of $348
Emergency Fund: $5,000 (in addition to the $15,000 to invest)
Before I layout what I would do in this situation, I should remind everybody that I’m not a financial adviser. I’m just a guy with a blog and a bad haircut. I should also add that reasonable people could disagree on what is best in this situation. That being said, I can describe what I would do if this were my situation.
First, I would not invest in peer to peer lending. Readers of The Dough Roller know that I have loans invested with both Prosper and Lending Club. Frankly, at this point in the evolution of P2P lending, I view these investments as an experiment as much as anything else. I enjoy analyzing loan portfolios and the risks they present. But P2P lending is not appropriate, in my opinion, when you’ve got a ticking time-bomb of a mortgage set to detonate in 2010.
Second, I’d consider my future plans with the home. If I plan to sell the home before the rates adjust in 2010, I wouldn’t refinance. Refinancing costs money that I would never recoup, and the current interest rate of 6.375% is reasonable. I’ll assume here, however, that I plan to stay in the home long past 2010.
Refinance now, later or never
Finally, the big question of whether to refinance, and if so, when and to what type of mortgage. If I were going to stay in this house for the long term, I definitely would refinance. I think for most, a 15 or 30-year fixed rate mortgage is the best option. Variable rate mortgages introduce unnecessary risk into an individual’s finances, and frankly, offer little in return. The big question here is when and how to refinance. There are a number of things to consider:
- Down payment: With just $15,000 to put toward the mortgage, a 20% down payment is out of the question. This means either she will have to pay private mortgage insurance (PMI) or refinance into two loans. The first loan would be a fixed rate mortgage for 80% of the home’s value ($172,000) and either a home equity loan or line of credit for the remainder. The second loan will come with a higher interest rate, but once it’s paid off, the total monthly payment obviously goes down.
Interest rates: It seems that just about everybody believes they know where interest rates are heading. I’m a firm believer that we don’t. If asked four years ago, how many of us honestly thought interest rates would remain this low for this long? Rates on mortgages are still at historic lows, so I would not make my decision based on where I thought interest rates would be in the future (even though I personally believe they will go down before going up).
Home value: Her home has dropped in value since 2005. If it goes down any further, she will owe more than the house is worth. That means the $15,000 will represent even less of a down payment than it does today. Of course, the home value could go up. As with interest rates, I would not attempt to predict where home values were heading (or I’d assume the worst).
I would refinance now. In an ideal world, I would determine if I could save a 20% down payment before the interest rate adjusts in 2010. If I could, I’d hold off refinancing, but keep a keen eye on interest rates. If rates started to go up, I may refinance even before saving enough for a 20% down payment. The problem here, however, is that the home has dropped in value and is now worth the same amount as the current mortgage. If the home value drops further, it may prevent the owner from refinancing at all with just a $15,000 down payment. I would view this as my biggest risk.
As for what type of mortgage, I’d likely choose a 30-year fixed rate loan. The lower payments as compared to a 15-year loan would give me more financial flexibility each month to invest the extra money or pay off the car loan. I should add, however, that if rates go low enough, I will be refinancing my own 30-year mortgage into a 15-year note, but my situation is unique for reasons not worth describing now. The point is that the debate over 30-year versus 15-year mortgages, while interesting, is misplaced in my opinion. Either is a good option, and you can always pay a 30-year mortgage in 15 years if you want.
So that’s what I would do–refinance now assuming I could get a competitive rate. I’d likely refinance into two loans: (1) an 80% first mortgage amortized over 30 or 15 years; and (2) a home equity line of credit for the remaining amount.
Now it’s your turn. What would you do if you were in this situation? And if you’re facing a financial decisions and are looking for some input, send me an email at dr [at] doughroller [dot] net.