Bad Advice
In this month’s issue of Money, the cover (also on page 81 for readers) is a financial recommendation for a family who has a lot of equity in their house but few financial assets. Here is a summary of their financial condition:
1) They are both 46 and have a 5 year old son
2) Their home is worth $1 million
3) They have a $250,000 ARM (adjustable rate mortgage) that is about to be adjusted upward
4) They only have $100,000 in retirement accounts
5) They have $30,000 outstanding on a home equity line
6) They have $12,000 in credit card debt
7) Their income is variable but usually exceeds $120,000
8) They are only saving a few thousand dollars a year in one 401(k)
Looking at this problem, there are a few things that jump out at me. First, they have too much of their assets in their house. Second, they are probably not saving much – as evidenced by their credit card debt and home equity line. Third, they will need to refinance their ARM soon.
The financial planners consulted by the magazine came up with a controversial and risky plan to “save” the couple. They advise the couple to take out a new $500,000 ARM and invest the proceeds in a mix of stocks and bonds, after paying off the credit cards and home equity line. This will bring their total portfolio to about $300,000 but will increase their monthly payments substantially.
Their recommendation is crazy! It is obvious from the information given that they are currently spending more than their current income. Why else would their incur credit card debt and have a home equity line of credit? Taking on a larger mortgage is the last thing they need. It will surely lead to more credit card debt and a larger home equity line.
In addition, I see no sense in taking out debt to buy bonds that yield less than the interest rate on the debt incurred. They estimate the ARM will have a 6% interest rate, while the bond mutual funds they recommend are currently yielding 3.2% and 4.75%. I will gladly pay you $4 per year if you pay me $6. The advisors are blindly following an asset allocation strategy without realizing that they are in fact selling short bonds at 6% and going long bonds at 4%. In addition, the “short” bonds are risk-free to the investor, while the bonds they are buying have risk.
Lastly, the advisors claim that since the couple is behind on their saving, they need to take risk. Even assuming they are behind (which they may not be, discussed below), there is no sense to taking more risk. In fact, they cannot afford to take more risk. By definition, taking more risk means a higher probability of losing money. At this point they can’t afford to lose a lot of money. In addition, they probably won’t have the patience to lose much money so if their trade turns against them, they will likely sell at a loss.
The real solution would be to give the family the following options: (1) refinance to a fixed rate mortgage (preferably a 15 year mortgage) and set aside a few hundred dollars each month into their retirement funds OR (2) downsize to a smaller house and put the equity into a diversified portfolio of stocks. The second option is the better option financially but the harder option emotionally. It is hard to tell people the reality of their situation.
But, I have serious doubts that the couple can afford a $1 million home with the income and family responsibilities they have, especially considering their use of credit card debt and a home equity line of credit in the past.
