A number of you have asked me whether you should do a cash-in refinance so I’d like to share my thoughts on this interesting scenario. A cash-in refinance is basically when you pay down your existing mortgage to under a certain loan-to-value ratio in order to qualify for a mortgage refinance.
Loan-to-value is calculated by taking your mortgage divided by the value of your property. A LTV of 80% or lower is generally what is required by most big banks nowadays in order to refinance e.g. $400,000 mortgage, $500,000 house. For rental property buyers, banks usually require a 30% downpayment or more, which equates to a LTV of 70% or lower.
Mortgage rates have come down significantly over the past 10 years thanks to the Federal Reserve’s loose monetary policy, lower inflation rates, increased demand for fixed income instruments, and difficult economic cycles. I was personally stuck with a 30-year mortgage of 5.875% on my vacation property because the condotel secondary mortgage market shutdown after the collapse. For years, I longed to refinance down to 4.25% or lower, but I didn’t want to throw more cash into an illiquid asset. Instead, I was able to get a loan modification for free from Bank of America.
But let’s say you can’t get a loan modification and desperately want to lower your mortgage interest rate. The only other option is to do a cash-in refinance.
Current Mortgage Situation
Mortgage rate: 6%
Duration: 30 year fixed
Mortgage amount: $400,000
House value today: $400,000
House value in 2007: $500,000.
Loan-To-Value Ratio: Increased from 80% to 100%, prohibiting you from refinancing to a lower rate.
Monthly mortgage interest: $2,000
Yearly mortgage interest: $24,000
The bank is offering to refinance your 30-year fixed mortgage from 6% down to 4% if you pay down your mortgage to get to an 80% LTV. An 80% LTV on a $400,000 house means a mortgage of $320,000. In other words, you’ve got to come up with $80,000 in cash to bring your current $400,000 amount down to $320,000 to qualify. So how do you figure this out?
Proposed Mortgage Situation
Refinance mortgage rate: 4%
Duration: 30 year fixed
LTV requirement: 80%
Cash needed to reach 80% LTV on a $400,000 home: $80,000
New mortgage amount: $320,000
New monthly mortgage interest: $1,067
New yearly mortgage interest: $12,800
SOLUTION: Take the difference in your old and new annual mortgage interest amounts ($24,000 – $12,800 = $11,200) and divide by the amount of money the bank requires you to contribute ($80,000) to get 14%. The 14% is essentially the rate of return on your cash-in investment refinance, which is excellent compared to historical returns in the stock market, bond market, and real estate market.
Formula: (Old Annual Interest Payment – New Annual Interest Payment) / Cash-In Amount = Return On Cash-In Refinance
It would be nice if we could make all our decisions based on simple math. The reality is there are multiple variables we need to also consider. Here are things to think about.
1) Duration. Cash-in refinances work only if you plan to own the property for a long period of time, preferably the duration of the loan. You should not plan to foreclose on the property even if you are in a non-recourse state because you will probably lose a lot of your cash injection. If you sell the property on the open market, you should theoretically be able to extract the equity out of your house, but it depends on price and market conditions. Don’t do a cash-in refinance if you don’t plan to own the property for at least 10 years. You can also simply calculate how many years of interest savings it will take to recoup your investment. In the example above, the answer is $80,000 / $11,200 = 7.2 years. Hold on for at least 7.2 years to break even. Any shorter holding period and you are wasting your time.
2) Alternative Investments. A 14% return on your cash-in refinance is hard to beat. However, there might be better returns out there. You can accept a lower rate of return than 14% if alternative investments provide more liquidity and flexibility. For example, if there’s a stock you believe will provide a 10% return, the stock may very well be a more attractive investment because you can easily sell after your gain. You should also make sure you’ve exhausted all alternative solutions before going the cash-in refinance route.
3) Employment. If you work in a volatile industry, feel your job might be at risk, and only have one or two income streams, then investing more cash into your house, despite the monthly interest savings may be a little too risky. You can at least prepare for potential unemployment by reading this post on 15 things you should do before quitting your job. In general, it’s better to be cash rich and house poor due to liquidity.
4) Upcoming Expenses. Definitely list out as many small and big ticket upcoming expenses as possible. Some common expenses include travel, tuition, cars, taxes, roofs, water heaters, windows, and medical. Make sure you are able to comfortably pay for as much upcoming expenses as possible before investing a big chunk of change in your mortgage.
5) Reduced tax shield. The reason why I think the ideal mortgage amount is $1 million is because $1 million in mortgage indebtedness is the maximum amount you can have to deduct mortgage interest from your income. You can get a $100,000 HELOC as well, but that’s a grayer matter. With a lower mortgage rate you will obviously have less interest expense. That said, it’s better to pay less interest than more interest even if you have a shield. For those who make much more than $200,000 your deductions get phased out.
6) Cost to refinance. My general rule of thumb is to refinance whenever it takes 24 months or less to recoup the refinance costs. The quicker the break even point the better obviously. If you have a mortgage large enough, the costs are often embedded into the refinance and you can start saving money from the first month forward. The longest duration is simply living in your property for at least the amount of time it takes to recoup the cost e.g. even if it takes 10 years, if you live in your house for 11 years you win, but by only one year.
7) Net Worth Diversification It’s important to keep your net worth reasonably diversified. If a cash-in refinance causes the property portion of your net worth to grow to much more than 70%, you should really think carefully about whether you can grow the other portion large enough to get the property balance lower. You can easily see a snapshot of your net worth distribution if you aggregate your accounts on Personal Capital. It’s free and easy to use.
If I didn’t get a loan modification for my vacation property I probably would have still held off on a cash-in refinance because I need cash. As a first year entrepreneur/retiree/unemployed person, it’s best to have as much semi-liquid cash on hand as possible since I’ve never flown solo before. Now that a year has past, I’m much more comfortable deploying as much cash as possible into investments as well to reducing mortgage debt because I’ve figured out my cash flow needs.
For those of you who have a property LTV of around 81-100% and can comfortably go through all the scenarios above, I’d strongly consider doing a cash-in refinance. For those of you who have property with an LTV much higher than 110%, I’d say wait a bit longer for the market to recover even if you plan to stay forever. Your house value should eventually recover. But it might take longer than expected and life circumstances might change.
To begin the talks of a potential cash-in refinance, simply ping your existing mortgage holder for various options and check rates online since it’s free with no obligation to make sure you’re not getting gouged. With the 10-year yield over 2% currently, I’m afraid that the good times are ending for low mortgage rates.