Return on investment can beat other low-risk options
Cash-in refinancing means putting cash into a transaction by paying down the balance, as opposed to cash-out refinancing where you take cash out by increasing the balance.
Cash-in refinancing has become a hot topic recently because in the current market it is possible for mortgage borrowers to earn a very attractive rate of return on money invested in a balance paydown, at the same time that the returns available on other low-risk investments, such as government securities, CDs and money market funds, are lower than they have been at any time since the 1930s.
The high returns available from cash-in refinancing reflect several features of the current financial scene. Interest rates on very low-risk mortgages have never been lower, creating large spreads between those rates and the rates now being paid by millions of borrowers on their existing loans.
The problem is that the lowest rates on new mortgages are available only to borrowers who meet the risk requirements, which most do not.
These requirements include not only good credit and adequate income, but homeowner equity of 20-25 percent, which translates into loan-to-value ratios (LTVs) of 75-80 percent on new loans.
Many homeowners cannot meet the LTV requirement because of the decline in home prices that has occurred over the last four years. Further, mortgage insurance premiums on loans with LTVs above 80 percent have increased significantly for those without the very best credit.
Cash-in refinancing makes the best rates available to borrowers who would otherwise qualify for them but don't have enough equity in their property. Paying down the loan balance reduces the loan-to-value ratio on the new loan, which reduces the interest rate, mortgage insurance premium, or both.
The balance paydown, and the lower interest rate it makes possible, reduces both the monthly payment over the period the borrower expects to be in the house and the balance that has to be paid off at the end of the period.
The principal question the borrower should ask is whether the rate of return on the money used to pay down the balance and cover the closing costs on the new loan exceeds the return on alternative investments available to the borrower.
With Chuck Freedenberg, I developed a new calculator that shows the rate of return on an investment in a loan paydown in connection with a refinance. It is calculator 3f on my website.
Here is an example: John has a 6 percent mortgage with 300 months to go and a $100,000 balance, but his house is worth only $100,000, which makes him ineligible for a refinance. However, if he pays down the balance to $80,000, he can refinance into a 4.5 percent loan with closing costs of 2 percent.
If John stays in the house for five years, the rate of return on his investment, consisting of $20,000 in balance paydown plus $1,600 in closing costs, would be 9.98 percent. The return is riskless to the borrower.
The rate of return depends on the size of the rate reduction, closing costs on the new loan, how much must be invested to get to an 80 percent LTV, and on how long the borrower expects to have the mortgage.
To illustrate: If John's house is worth $118,000 rather than $100,000 so that he has to invest only $5,600 to get to an 80 percent LTV, his return would jump from 9.98 percent to 21.09 percent. If the new rate is 5.25 percent rather than 4.5 percent, the return would fall from 21.09 percent to 10.41 percent.
If closing costs are 1 percent rather than 2 percent, the return would rise from 10.41 percent to 15.13 percent. And if John sells the house after only two years instead of five, his return would fall from 15.13 percent to 9.45 percent. You can find the returns applicable to your deal using calculator 3f.
Readers who use calculator 3f will notice that it calculates two rates of return. The numbers cited above compare the paid-down mortgage with the current mortgage. The second return compares the paid-down mortgage with a new mortgage that does not have a paydown, and therefore will carry either a higher rate or a mortgage insurance premium.
The second rate of return is for borrowers who can refinance profitably without a paydown, and are therefore not quite sure they want to invest the money in making the refinance more attractive. The return relative to the refinanced loan without a paydown will be lower.
Suppose John's house in the example above is worth $111,200, so that his current balance of $100,000 is 90 percent of value.
In this situation, he can refinance without a paydown by paying mortgage insurance, which I priced at $52 a month. Assuming a rate of 4.75 percent and closing costs of 1 percent with or without the paydown, the returns over five years on an investment in paydown are 14.06 percent relative to the current mortgage, and 10.75 percent relative to a refinance without paydown.
Note that if the return relative to a new loan without paydown is higher, it means that a refinance without a paydown is a loser and should be avoided.
Jack Guttentag, Inman News September 3, 2010u