Should I Do A Cash-IN Refinance? The Benefits And Risks Of Paying Down A Mortgage For A Lower Rate

Cash-In Refi A San Francisco MansionA 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, more efficient 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.

HOW TO DECIDE WHETHER 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

MORE THINGS TO THINK ABOUT WHEN DOING A CASH-IN REFI

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 and what’s it like being unemployed. 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.

CASH-IN REFINANCES CAN WORK

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.

RECOMMENDATION FOR HOMEOWNERS

Shop around for a mortgage. LendingTree Mortgage offers some of the lowest refinance and new mortgage rates because they have a huge network of lenders to provide mortgage loans, home equity loans, and home equity lines of credit. If you’re looking to buy a new home, consider using LendingTree to get multiple offer comparisons in a matter of minutes. When banks compete, you win.

Updated: 5/10/2014

Regards,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. krantcents says

    Nice explanation! Usually, people in those situations do not have a choice. If it is a small amount to reach the 80% LTV, it may make sense. There also the consequence of PMI, if you do not have an 80% LTV too.

    With interest rates so low, I am seriously thinking of the opposite, cash out. I have been turned down for a refi because my balance is too (low $50K) low. Crazy solution for a crazy situation.

    • David M says

      I say be crazy and weird and pay off your mortgage. That is don’t take a cash out mortgage.

      I owe about $120,000 on a loan that was $320,000 5 years ago. I have refinanced from 5.25 to 4 to 3.5.

      I can not stomach doing the paperwork again, thus I am paying off the mortgage like a mad man – an extra $5,000 a month for the last 3 months.

      • David S. says

        Totally agree, I say do what makes you sleep better at night. For me personally it was knowing that my mtg balance was reduced and the amount of years I am paying is also shortened.

        Original loan: 30 year fixed @ 4.625 (June 2009)
        Refi loan: 15 year fixed @ 3 (Nov 2013)

        I had to make a ballon payment towards principal to lower my monthly payment amount to compensate for the excelerated payment schedule of the 15 year loan. Not only will I save approx 200k in interest payments over the course of my original loan, I’ll own my property in a shorter period of time.

    • Financial Samurai says

      Hmmm, with a $50K mortgage balance, I wouldn’t bother refinancing. A cashout, or reverse mortgage for you might work if you’re looking for more cash flow in your retirement years.

  2. Chris says

    I don’t know if you rent it out so take this FWIW:
    Let’s say the vacation property can rent for $1,800/month and your mortgage is $1,500. Not only do you get the upside of everything being paid for by tenants, but also building up cash in the bank for repairs and maintenance on the place or even more ROI if repairs/maintenance aren’t that much.
    As you said, a 14% ROI for putting $80k in and lowering your carrying costs is significant. How much would your closing costs be aside from the $80k to get it down to 80% LTV?

  3. Untemplater says

    Very helpful tips Sam. I’ve never done a cash in refinance myself. I agree it’s good to talk to your mortgage broker and see what types of options they can offer and see which make the most sense financially.

  4. Lucas says

    I took the route of paying off my house quickly, but I am honestly having second thoughts with interest rates so low as well. My thoughts shift depending on how I think about my money :-) If i think about it as i have a 300k investment earning $1500 a month (what I would be paying for rent – property expenses) – which is roughly 6% ROI, and getting 3-5% appreciation for a total of 9-11% ROI it sounds pretty good. But then of course I realize that I could be getting all of that while potentially earning an additional 6-7% on that 300k (invest at 9% return while paying 3% tax deductable interest), and i start to reconsider. Not that I am in a bad spot, but it is certainly a risk to reward trade I am considering.

    • Financial Samurai says

      It’s definitely up to us to figure out what the right balance is. In good times, it’s easy to look with longing eyes at stock names such as Tesla up 100% and get disappointed at our other returns.

      I personally never plan to pay off my primary home so long as I have 25% or higher taxable income. Here’s a post I wrote on the ideal mortgage amount.

  5. JayCeezy says

    In 2005, mortgage brokers were offering 105% LTV, with a second mortgage. I know, right? Things change.

    My case might fit in with the #3) Employment; I’m no longer employed, a bit further along in my investing cycle so needing to reduce/eliminate risk, and can’t get anything close to a 3.5% return. So I paid off my home, and like David M and David S noted, it does allow me to sleep better.

    I have witnessed how badly things can go wrong when a ‘cash-out’ goes sideways. A longtime pal lost 9 rental properties, when the market turned; he had invested the cash in the stock market, which simultaneously cratered. He lost it all, and will be working 15 years longer than planned. Many other ‘war stories’, but they all end the same way: in tears. But for younger investors with years ahead on their investing horizon, the only way to make the big jumps in NW is by assuming risk. For those doing this, I hope it works out well.

    • JayCeezy says

      In the mid-90s, I did a Cash-In mortgage, in order to get the outstanding balance below the ‘conforming’ limit. It was worth an extra half-percent, during a decades-long period of declining interest rates. As FS has noted, rates have been declining for 30 years. They really can’t go lower, and when they begin to rise the people who have locked in these @3% loans will appear to be savants. My father locked in a 5% loan in 1966, and when mortgage interest rates hit 18% in 1979. Genius!:-) My point is that nobody was considering a Cash-In mortgage from 1966 through 1979. Today?! Hellz yeah~!

  6. Fred K says

    I am currently doing a cash IN refi to capture these low rates. In my situation, I decided to accelerate my payoff from my current 13 yr remaining to a 10 yr.

    You might also mention:

    * IRS interest deduction will decline with the new mortgage
    * The costs to refi (fees)
    * the various trade offs with shortening or lengthening the term

  7. John says

    PMI was a big factor in my decision to do a cash-in refinance. PMI is a shorter term impact but it can be a large part of the rate of return for those early years…

  8. retirebyforty says

    My current rate is 4.25% so I don’t think it’s worth doing cash in finance. From 6% to 4%, that’s a pretty good reduction.
    I probably can’t get a mortgage loan anyway since I don’t have a job anymore.

    • Financial Samurai says

      The fees should be roughly the same, but everything is negotiable. The bank is happier with Cash-INs then Cash-OUTs or simple no cash change refis as their view of your credit risk goes down with more skin in the game.

  9. Roshan | Olim Dives says

    Sam,
    Some of your readers may enjoy this Loan Amortization template that I developed to run what-if scenarios to calculate payments and savings by making additional payments – http://www.haironfirepm.com/2012/07/26/excel-template-amortization-schedule/

    I just did a cash-in refinance. As you stated they only make sense if you plan to keep the property for a longer period of time and you have the extra money. As loans are time based the savings in interest reduction are only realized after a period of time. If you plan to sell your home in 2 years you would be better served investing the money in another types of accounts.

    Good article!
    Roshan

  10. steve says

    Great article on refin
    Does the model change with a variable % rate ?
    I have a 400,000 adj variable % rate of the 6 mo Libor plus 2 3/4
    on a house that worth 350,000. I have 24 years left on the mortgage and I am paying about
    1500 on a my monthly payment of 1100.
    My math is not that great but my thought is as long a the 6 mo Libor is low.
    Cash is better in a mutual fund than buying down the mortgage and going to a fix.
    We are 62 and retired.
    How does one calculate a break point? any incite would be appreciated
    thanks
    steve

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