Help a Reader: CD-Secured Loans

Here's an email I recently received from a reader:

I am planning to purchase a second home for around $360,000.  My income is around $180,000 a year, and I have no debt, including no mortgage debt on my primary home worth about $180,000.  Due to the location and uniqueness of the second home (no comparables and so no possibility of a credible appraisal), I have been unable to secure a cost-effective mortgage, and so will pay around $300,000 in cash and finance the rest through CD-secured loans at my local credit union (this borrowed amount is a relatively small percentage of my financial net worth).  An interesting piece of this transaction is that I should pay the loans (there will be several CDs involved) off in around two years, and the credit union has a 1% off sale on the CD-secured loan interest rate, making the first year’s interest rate effectively 1%.  The second year, with a much lower balance, can be expected to be effectively 2% (I will go on receiving the interest on the CDs, and the loans cost the CD interest rate plus 2%).

My question is the worthiness of using this mechanism as a finance tool.  It will leave me with an adequate emergency supply of cash and my other investments and retirement funds intact.  I am not comfortable devoting more cash to this transaction since it would deplete my reserves below what I want for emergencies (I am 42 years old, married, with three children close to college age). I am primarily interested in the use of this financing tool as a viable, smart option.  As background, my wife and I are very conservative financially and make it a habit of spending much less than we make. 

Any thoughts for him?

Comments

[Cory]

Why are you buying the home? The financing seems like a good option since you have the rise in CD rates hedged with your emergency fund. I have never heard of such a loan. I assume there is still going to be a lien against your house?

[Brian S.]

Why do you need a second home? You say that you and your wife and financially conservative, but buying a second home without an obvious need for it doesn't seem very "conservative."

[Sarah]

If the man can put his hands on $300K in cash without touching his investments or his retirement, he's in a position where buying a second home isn't a crazy notion.

However, I'm puzzled by this "unique" home. Unless it's on Mars, what is the problem with the financing? When I hear "no comparators" I tend to think "scam."

[kitty]

Sounds like a good deal to me. I would probably consider takeing a higher and longer term mortgage as a hedge against probable future inflation - at least this is what my multi-millionaire friends did with their second home - but this is a matter of personal preference. Also depends on whether you believe we'll get inflation or deflation. I also have a paid off home and not having debts is a good feeling. But I also keep remembering 13% yield on my very first 6-month CD in 1983, and how some older guy I talked with was paying 9% on the mortgage he had taken some years prior. The guy had bought government bonds a couple of year before that yielding 18%... Many people believe history may repeat itself. I am not convinced, but it is a consideration. Regardless, this does sound as a good deal.

@Brian, Cory: IMHO, being "financially conservative" is relative. Second home is not financially conservative for someone who can barely afford to pay mortgage on the first home while may be very conservative for someone no debts, high salary and relatively high net worth. Someone who has a paid off primary home and can pay 300K in cash and with what is obviously not the last money can obviously afford a second home. Easily. He probably also has enough money for emergencies and is saving enough for retirement. So why shouldn't he buy a second home? It could be just another investment. Even if it is not, life is not just about necessities.

Sometimes opinions on these blogs can be so "absolute". "you must not spend money on flat screen TV", "you shall always buy a used car". Thinks about it: one person may need years to save for something, another person may cash flow the expense. I think FMF once had a post in which he considered cost of things relative to one's salary i.e. $2000 for one person may be the same as $2 for another person.

To me "financially conservative" means spending less than you earn and saving a sufficient amount of money that you'd have enough in emergencies as well as comfortable retirement. After that, one can enjoy the rest of the money.

[MelMel]

The CD's are the collateral, thus there is no lien against his house; otherwise, a lien would put this back to being a mortgage. He is simply getting a secured loan (secured by CD's, not real estate). As far as the real estate is concerned, there are myriad properties in this world that are unique and in locations that do not provide any comps. I would not assume this is a scam so quickly.

[Christine]

Wait until the cds mature and offer again. Or offer the cash amount you have as a low bid and see if the seller will accept.

[Maria]

I agree with MelMel and Kitty, from the info porvided, it appears to be a purchase the buyer can make and isn't asking if he should, but how.
As a mortgage underwriter, at a credit union, I have run into cases where the collateral is the property and the CD's. It is called cross collateralization. It allows the buyer to pledge the house and cd's if the interest writeoff is needed for income tax purposes.
Please note in this real estate market a home that is difficult to comp might be an incredible opportunity for someone with cash. I recent assisted someone with a geodesic dome purchase. Over 3000 sq ft all the latest and greatest in the house. It was on the market for over a year at almost 600,000. Ended up being purchased for mid $300,ooo's.
Absolutely stunning home, but limited appeal, and no comps-for readers that dont undersand this term- it is a comparable sale. Real estate appraisals work on the principal of substitution. Property being purchased is only worth what at least 3 most recent similar close properties are worth.
So the purchase of a(as an example)Ranch with 3 bedrooms and 2 baths has to be compared to 3 other sold ranches with in 1 mile and sold(closed)in the past 90 days. Has to have similar utility such as size, and for appraisales unique is bad.
Unique means a bank or lending institution cannot guage what to lend because it is an unknown as to appeal and subsequently value.
If you are in the market tor a home and have cash and like things that are different, it is a great buying opportunity

[Apex]

Sounds like a very good financing option.

Another one is a HELOC on your primary. You can get some really attractive variable HELOCs right now if you look hard enough. Obviously the variable nature of them is a long term problem but if you expect to have it paid off in 2 years then that is moot. You can still deduct the interest for up to 100K on the HELOC even if its not used to enhance your primary where as the CD secured loan is probably not tax deductible. However with your income you may hit AMT and if you do the HELOC will not be deductible.

Why you are getting a second is your business and I will make no prejudgements about that. The means you are using to do it seem very prudent.

[Jim]

Sounds like a good plan to me.

$60k in debt secured with CD's is not bad. He's basically paying 1-2% spread on the amount for the insurance of keeping his cash on hand and ability to buy the home now.

Their income is high and they're paying $300k in cash for the home plus own their home outright. They seem in very good financial condition. If they need / want to buy a 2nd home for whatever reason then I see no reason why not.

[Cory]

I didn't mean to come across as second guessing the decision. I was just curious why they were buying the house. Investment property, vacation home, etc. The financing seems great.